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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD
FROM _____________ TO _____________.
COMMISSION FILE NUMBER: 0-27644
DIGITAL GENERATION SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 94-3140772
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
875 BATTERY STREET
SAN FRANCISCO, CALIFORNIA 94111
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(415) 276-6600
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
NOT APPLICABLE
(FORMER NAME, FORMER ADDRESS, FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT)
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Sections 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES X NO __
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of the registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. [ ]
The aggregate market value of the voting Common Stock held by
non-affiliates of the registrant, based upon the closing sale price of the
Common Stock on March 15, 1999, as reported on the NASDAQ National Market, was
approximately $99,486,540. Shares of Common Stock held by each officer and
director of the registrant and by each person who may be deemed to be an
affiliate have been excluded. This determination of affiliate status is not
necessarily a conclusive determination for other purposes.
As of March 15, 1999, the registrant had 26,529,744 shares of
Common Stock, without par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
The registrant has incorporated by reference into Part III of this Form 10-K
portions of its definitive Proxy Statement for its Annual Meeting of
Shareholders to be filed within 120 days after the end of the fiscal year, (the
"Proxy Statement") and to be held on the date set forth in such Proxy Statement.
Except with respect to information specifically incorporated by reference into
this Form 10-K, the Proxy Statement is not deemed to be filed as a part hereof.
================================================================================
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DIGITAL GENERATION SYSTEMS, INC.
The discussion in this Report contains forward-looking statements that involve
risks and uncertainties. The statements contained in this Report that are not
purely historical are forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Words such as "anticipates," "believes,"
"plans," "expects," "future," "intends," and similar expressions are used to
identify forward-looking statements. All forward-looking statements included in
this document are based on information available to the Company on the date
hereof, and we assume no obligation to update any such forward-looking
statements. The Company's actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including, but not limited to, those discussed in "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Certain Business
Considerations" as well as those discussed in this section and elsewhere in this
Report, and the risks discussed in the Company's other United States Securities
and Exchange Commission filings.
TABLE OF CONTENTS
PART I
ITEM 1. BUSINESS........................................................................................1
Industry Background................................................................................1
The Company........................................................................................2
Products and Services..............................................................................3
The DG Systems Network.............................................................................4
Markets and Customers..............................................................................5
Sales, Marketing and Customer Service..............................................................6
Competition........................................................................................8
Intellectual Property and Proprietary Rights.......................................................9
Employees..........................................................................................9
ITEM 2. PROPERTIES.....................................................................................9
ITEM 3. LEGAL PROCEEDINGS.............................................................................10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...........................................10
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT..........................................................11
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.........................13
ITEM 6. SELECTED FINANCIAL DATA.......................................................................14
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.........15
Overview..........................................................................................15
Results of Operations.............................................................................16
Quarterly Results of Operations...................................................................21
Liquidity and Capital Resources...................................................................22
Certain Business Considerations...................................................................23
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA....................................................34
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISLOSURE...........34
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............................................35
ITEM 11. EXECUTIVE COMPENSATION........................................................................35
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................................35
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................................................35
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K...............................36
EXHIBITS AND REPORTS ON FORM 8-K.........................................................................36
SIGNATURES...............................................................................................40
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PART I
ITEM 1. BUSINESS
Digital Generation Systems, Inc. ("DG Systems", "DG" or the "Company")
operates a nationwide, value-added digital network which links hundreds of
advertisers and advertising agencies with more than 7,500 radio and 600
television stations across the United States and Canada. The Company's
fault-tolerant Network Operation Centers located in San Francisco and Vancouver
deliver audio, video, image and data content that comprise transactions between
the advertising and broadcast industries.
As a result of its September 1998 acquisition of Digital Courier
International, Inc., ("DCI"), a provider of electronic distribution and
communications services for the radio broadcast industry, the Company is now the
most significant provider of audio spot advertising to radio stations, enjoying
a market share in excess of 40%. In late 1996, the Company entered the market
for the electronic distribution of digital video spots to television stations,
cable systems and networks. DG Systems generates its revenues principally from
advertising agencies, advertisers, tape duplication vendors and dealers,
syndicated programmers and music companies that principally service these
markets. The Company believes that its digital network enables rapid,
cost-effective and reliable transmission of audio and video broadcast content,
and provides higher levels of quality, control and flexibility than physical
distribution methods currently available. In July 1997, the Company purchased
Starcom Mediatech, Inc. ("Mediatech"), a provider of broadcast video and audio
duplication, syndicated program distribution and corporate media duplication
services, with facilities in Chicago, Los Angeles and New York, augmenting its
November 1996 acquisition of PDR Productions, Inc. ("PDR"), a New York
City-based broadcast production services company. As a result of these
acquisitions the Company also has become a leading provider of video advertising
distribution and is rapidly adding new customers to its digital audio and video
network. The Company offers a complete range of post production services,
including editing, duplication, color control, close captioning, content review,
quality assurance, archiving and format conversions, all of which allow one-stop
shopping in the critical advertising markets of New York City, Chicago, and Los
Angeles.
INDUSTRY BACKGROUND
While many radio and television broadcasters now embrace digital
technology for much of their production processes and in-station media
management, current methods for the distribution of audio and video advertising
content are based primarily on the manual duplication and physical delivery of
analog tapes. According to industry sources, there are approximately 10,000
commercial radio and 1,100 commercial television stations in the United States.
These stations generate revenue principally by selling airtime to advertisers.
Advertising is most frequently produced under the direction of advertising
agencies for large national or regional advertisers, or by station personnel for
advertisers that are local in nature. Advertising is characterized as "network"
or "spot", depending on how it is bought and distributed. Network advertising
typically is delivered to stations as part of a "network feed" (bundled with
network programming), while spot advertising is delivered to stations
independently of other programming content.
Spot advertising airtime typically is purchased by advertising agencies
or media buying firms on behalf of advertisers. Advertisers and their agencies
select individual stations or groups of stations to support marketing
objectives, which usually are based on the stations' geographic and other
demographic characteristics. The actual commercials or "spots" typically are
produced at a digital production studio and recorded on digital tape. Variations
of the spot intended for specific demographic groups also are produced at this
time. The spots undergo a review of quality and content before being cleared for
distribution to broadcast stations. Tapes containing the spot and its variations
are then duplicated on analog tape, packaged, labeled and shipped to the radio
and television stations and cable head-ends specified by the advertiser or its
agency.
The predominant method for distributing spot advertisements to radio
and television stations traditionally has been the physical delivery of analog
audio or videotapes. The Company estimates that approximately 30% of radio spots
and more than 90% of video spots are delivered by air express services. Many
companies, commonly known as "dub and ship houses", are in the business of
duplicating audio and video tapes, assembling them according to
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agency-specified bills of material and packing them for air express delivery.
The Company estimates that it has transitioned approximately 60% of the market
for audio spot deliveries and approximately 10% of video spot deliveries, to
digital distribution. The Company estimates the market sizes for audio and video
distribution to be 4.5 million audio deliveries and approximately five million
video deliveries annually.
THE COMPANY
DG Systems is a leading provider of electronic and physical
distribution and ancillary post-production services for audio and video content
to advertising agencies, production studios and broadcast stations throughout
the United States. The Company, a California corporation, was incorporated in
1991. The Company has developed a digital network currently serving over 7,500
radio and 600 television stations that is controlled through the Company's San
Francisco and Vancouver Network Operating Centers ("NOCs"). This network enables
the rapid, cost-effective and reliable electronic transmission of audio and
video spots and other content and provides a high level of quality,
accountability and flexibility to both advertisers and broadcasters. With DG
Systems' network, transmissions are automatically routed to stations through a
computerized on-line transaction and delivery system and arrive at stations in
as little as one hour after an order is received. Typically associated traffic
(text) instructions are simultaneously transmitted by facsimile to minimize
station handling and scheduling errors. Shortly after a spot is delivered to a
station, the Company sends the customer a confirmation specifying the time of
delivery. Additionally, the Company's digital network delivers close to "master"
quality audio or video to broadcast stations, which is equal to or superior to
that currently delivered on analog tape.
DG Systems generates its revenues from advertising agencies as well as
from production studios and dub and ship houses that consolidate and forward the
deliveries to broadcast stations. The Company has historically operated and
currently operates without substantial backlog. The Company receives
distribution orders with specific bills of material, routing and timing
instructions provided by the customer. These orders are entered into the
Company's computer system either by the customer or by DG Systems and are
scheduled for electronic delivery if a station is on the Company's network, or
are scheduled for physical delivery via the Company's various dub and ship
facilities if a destination station is not on the network.
Audio content is received electronically at one of the Company's NOCs
from Record Send Terminals ("RSTs") and, in the case of Digital Courier's
network, Client Workstations ("CWs"), that are owned by the Company and deployed
primarily in production studios. Audio can also be received using the Company's
"iAudio" internet audio collection system. When audio spots are received,
Company personnel quality-assure the audio content and then initiate the
electronic transaction to transmit various combinations of audio to designated
radio stations. Audio transmissions are delivered over standard telephone or
ISDN lines to servers that the Company has placed in each radio station.
The audio spots are thereafter available to the station on demand.
Video content is received electronically at the Company's San Francisco
NOC primarily from DG Video Record Transmission Systems ("VRTSs") that are owned
by the Company and deployed in production video studios. Video content also can
be received at the Company's San Francisco NOC through airfreight carriers or
through high-speed communication lines from collection points in locations where
VRTSs are not available. When video spots are received, Company personnel
quality-assure the spots and release the video to the NOC, where it is combined
with the customer's electronic transaction to transmit the various combinations
of video to designated television stations. Video transmissions are sent via a
high-speed frame relay link to the digital satellite uplink facility over which
they are then delivered directly to servers that the Company has placed in
television stations and cable interconnects.
Audio and video transmissions are received at designated radio and
television stations on DG-owned servers, called Receive Playback Terminals
("RPTs"), Client Workstations ("CWs") and ADvantage Digital Video Playback
Systems ("DVPS"). The servers enable stations to receive and play back material
delivered through the Company's digital distribution network. The units are
owned by the Company and typically are installed in the "master control" or
production area of the stations. Upon receipt, station personnel generally
review the content and transfer the spot to a standardized internal station
format for subsequent broadcast. Through its NOCs, the Company monitors the
spots stored in each RPT, CW, or DVPS and ensures that space is always available
for new transmissions. The Company can quickly transmit audio or video at the
request of a station or in response to the request of a customer who wishes to
alter an existing order, enabling responsiveness not possible in a physical tape
distribution system.
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DG Systems currently offers four primary levels of digital audio
distribution services and three levels of video distribution services from its
NOCs to broadcast advertisers distributing content to broadcast stations: DG
Priority, a service which guarantees arrival of the first audio spot on an order
within one hour (available for audio only); DG Express, which guarantees arrival
within four hours; DG Standard, which guarantees arrival by noon the next day;
and DG Economy, which guarantees arrival by noon on the second day. The Company
also offers a set of premium services enabling advertisers to distribute audio
or video spots provided after normal business hours and, therefore, after
overnight parcel delivery service is no longer available.
In addition to its standard services, the Company has developed unique
products to service four vertical markets with particular time-sensitive
delivery needs. "Sweeps" delivery is a specialized service for television
stations that wish to advertise on radio with either topical or cooperative
content to stimulate viewership during the periods of ratings measurements
conducted by the A.C. Nielsen Company. The Company also offers delivery of
advertising for daily newspapers seeking to expand their readership based on a
dissemination of breaking news during the morning rush hour. The Company
distributes first release music singles and uses unique software functionality
to insure that the singles are released throughout the country to all stations
simultaneously thereby eliminating concerns of favoritism or premature release.
Finally, the Company delivers political advertising during election campaigns,
providing a rapid response mechanism for candidates and issue groups.
The Company also provides audio and video duplication services,
syndicated programming distribution services, and a host of other ancillary post
production services through its nationwide facilities in New York, Chicago,
Louisville and Los Angeles.
PRODUCTS AND SERVICES
The Company's mission is to become the leading provider of electronic
value-added transaction services to the advertising and broadcast industries.
Audio Advertising Distribution. Prior to the Company's acquisitions of
PDR and Mediatech, substantially all of the Company's revenues were derived from
the delivery of radio advertising from advertising agencies, production studios
and dub-and-ship houses to radio stations in the United States. In 1998, the
Company acquired DCI, and is in the process of consolidating DCI's network with
the Company's existing network to form a single, comprehensive network servicing
over 7,500 stations throughout Canada and the United States. Audio services are
expected to continue to account for a significant share of the Company's
revenues for some time. See "The Company" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Certain Business
Considerations -- Dependence on Radio Advertising." The Company also derives
revenue from its offering of audio distribution services in the four vertical
markets: sweeps; local/regional newspapers; music releases; and political
advertising. See "The Company." The Company provides two-way audio transmission
services to radio stations within markets, regions and co-owned groups,
facilitating the sharing of programming and commercial content. The Company also
derives limited revenue today through its studio services, which enable
production studios to directly exchange audio files with each other without the
intervention of Company personnel.
Postproduction Services. The Company's acquisitions of PDR and
Mediatech have enabled it to provide digital delivery to a larger base of
customers and to provide postproduction services in the three major advertising
markets (New York, Los Angeles and Chicago) for a "one-stop shopping solution."
The Company continues to focus on value-added postproduction services to
complement the Company's digital delivery product. Such services include leading
edge digital editing, digital closed captioning, Internet-based encoding, and
CD-ROM mastering and duplication.
Video Advertising Distribution. The Company believes that the delivery
of television advertising is characterized by many of the same challenges facing
radio advertisers. The Company introduced its video distribution services in the
third quarter of 1996. To date the Company has deployed a video distribution
network consisting of over 600 television stations and cable interconnects which
currently are on-line and receive video content through the Company's network.
The Company is actively marketing and selling its video services to agencies,
advertisers and dealers. As many of the Company's radio advertising customers
also are active television
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advertisers, its current customers who already utilize the Company's audio spot
distribution services are candidates for or already are utilizing its video
services. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Certain Business Considerations - Dependence on Video
Advertising Delivery Service Deployment", and "- Dependence on Technological
Developments" and " - Competition."
Syndicated Program Distribution. The Company also generates revenue by
distributing syndicated programming. This service primarily consists of
integrating commercials into syndicated programs and either uplinking the
completed programs via satellites for distribution to stations nationwide or the
physical duplication and shipping of shows to stations that do not receive a
satellite feed.
Corporate Duplication. The Company also generates revenues from the
duplication of corporate content. This service primarily consists of large
quantity duplication of training, corporate or product information tapes on
non-broadcast quality tape stock, such as VHS.
Music Distribution. The Company also derives revenues from its "first
release music deliveries," in which it offers music labels the capability to
electronically distribute first-release music singles simultaneously to selected
radio stations.
The Company's future growth depends on its successful and timely
introduction of new products and services, often in markets that do not
currently exist or are just emerging. The Company currently is undertaking
efforts to develop new products and services. There can be no assurance,
however, that the Company will successfully complete such development or that,
if such development is completed, the Company's introduction of these products
and services will realize market acceptance or will meet the technical or other
requirements of potential customers. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations - Certain Business
Considerations - Dependence on Emerging Markets."
THE DG SYSTEMS NETWORK
DG Systems has developed a sophisticated, highly scaleable network
communication system to provide network transaction services to the advertising
and broadcast industries. Today this system supports two-way communication
between advertisers, agencies, production studios and stations via standard
telephone lines, ISDN lines, digital data satellite frame relay connections and
the Internet. The Company intends to continue employing state-of-the-art
communications capabilities, such as XDSL and cable modems, as they become
widely available and economically feasible. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Certain Business
Considerations - Ability to Manage Growth" and " - Future Capital Needs;
Uncertainty of Additional Funding."
The Company's network consists of the following: (i) Record Send
Terminals and Client Workstations (audio) and Video Record and Transmission
Systems (video) owned by the Company and installed primarily at production
studios; (ii) NOCs at the Company's headquarters and in Vancouver, BC, Canada
used to assemble, process, route and store digital content; and (iii) ADvantage
Receive Playback Terminals and Client Workstations (audio) and ADvantage Digital
Video Playback Systems (video) owned by the Company and installed at broadcast
stations, cable interconnects and broadcast and cable networks.
Record Send Terminal and Client Workstation. Both the RST and CW are
PC-based audio encoder and communications servers with a full screen monitor and
keyboard. The RST accepts audio in either analog or digital format and encodes
the audio using an efficient algorithm for transmissions to the Company's NOC in
San Francisco.
Video Record Transmission System. The VRTS is a video encoder and
communications server with a full screen monitor and keyboard. The VRTS accepts
video in either analog or digital format and encodes the video using a standard
MPEG-2 compression algorithm for transmissions to the Company's Network
Operating Center in San Francisco.
Network Operating Centers. DG Systems has developed a fault-tolerant
client/server on-line transaction system based on relational databases and UNIX
servers from Sun Microsystems. The Company has developed software applications
incorporating critical operational capabilities such as transaction management,
communication
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facility monitoring, system security, intelligent network routing and customer
service databases. The major system components include (i) a transaction
scheduling, monitoring and management system, (ii) a media collection,
processing and delivery system which is designed to handle audio, video, image
and data organizing the delivery content by destination address, and routing
those deliveries by the most cost-effective route, and (iii) a high-capacity
media storage and archive system that indexes and archives every media file
delivered by the Company. The Company's Vancouver location also has a Network
Operating Center with similar capabilities.
ADvantage Receive Playback Terminal. The RPT is a rack-mountable,
PC-based communication server and media decoder that enables radio stations to
receive and play back audio content delivered through the Company's digital
distribution network. The RPT communicates with the Company's network to
exchange media and transactional information, and allows users to play back
broadcast quality audio on demand. RPT software consists of extensive remote
capabilities such as system diagnostics, storage management and remote software
upgrade as well as enhanced security features such as user authentication,
network access security protocol and media content encryption to prevent
unauthorized access.
ADvantage Digital Video Playback System. The DVPS is a rack-mountable,
PC-based communication server and video decoder that enables television stations
and cable systems to receive and play back advertisements delivered through the
Company's digital distribution network. The DVPS communicates with the Company's
network to exchange media and transactional information, and allows users to
play broadcast quality video on demand. The DVPS includes a fully integrated
monitor and keyboard and has the disk capacity to store up to 250 30-second
spots. DVPS software consists of extensive remote capabilities such as system
diagnostics, storage management and remote software upgrades as well as enhanced
security features such as user authentication, network access security protocol
and media content encryption to prevent unauthorized access.
Hughes DirecPC Satellite Interface. The Company has a joint development
and deployment agreement with Hughes Network Systems, Inc. for satellite
delivery to its network of stations. The Company has developed an electronic
interface between its NOC in San Francisco and the Hughes satellite uplink
facility. The Company also has integrated the Hughes DirecPC satellite
technology into its DVPSs to permit the receipt of media content from satellite
as well as from terrestrial connections.
Client Workstation. The CW is a rack-mountable or desktop, PC-based
communication server and media encoder/decoder that enables radio stations to
receive, play back, record and send audio content delivered through the
Company's digital distribution network. The CW communicates with the Company's
network to exchange media and transactional information, and allows users to
record, store and play back broadcast quality audio on demand. CW software
consists of extensive remote capabilities such as system diagnostics, storage
management and remote software upgrade as well as enhanced security features
such as user authentication and a network access security protocol to prevent
unauthorized usage of the network.
DG's extensive network of digital audio receive playback terminals and
video playback systems strategically placed across the country in broadcast
stations, its record send terminals, customer workstations and video record
transmission systems, coupled with unique encoding, compression and complex
communications software, connected via its NOCs described above, and an
established customer base, create important barriers to entry for potential
competitors. The transmission of content is controlled by a very comprehensive
transaction scheduling, routing, monitoring and delivery management system that
the Company believes would be very difficult to replicate. Additionally, DG's
audio and video capabilities now are complemented with facilities in New York
City, Chicago, Louisville, and Los Angeles to handle customers' other production
services needs. The Company believes that no single competitor today offers DG's
audio, video, and production services capabilities that are deliverable locally
and nationally via several strategic locations.
MARKETS AND CUSTOMERS
A large portion of the Company's current revenue is derived from the
delivery of spot radio and television advertising to broadcast stations, cable
systems and networks. The Company derives revenue from advertising agencies
directly and from its marketing partners, which are typically dub and ship
houses that have signed agreements with the Company to consolidate and forward
the deliveries of their advertising agency customers to broadcast stations,
cable systems and networks via the Company's electronic delivery service in
exchange for price discounts from the Company. The advertisements distributed by
the Company are representative of the five leading
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national advertising categories of automotive, retail, business and consumer
services, food and related products including soft drinks, and entertainment.
The volume of advertising from these segments is subject to substantial seasonal
and cyclical variations. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Certain Business Considerations -
Potential Fluctuations in Quarterly Results; Seasonality." Through its
acquisition of the assets of DCI, the Company has also acquired an additional
revenue stream from radio stations by providing distribution between radio
stations and radio groups.
In addition to its core distribution services, DG Systems has
identified vertical-market applications for services where same day delivery is
used to promote time-sensitive content. These applications include:
Sweeps Promotions. The A.C. Nielsen ratings periods take place during
the broadcast months of February, May, September, and November. The Company's
services allow local television stations, their affiliated networks and
syndicators, whose own advertising rates are based on their Nielsen ratings, to
promote viewership of their programs during ratings periods.
Station to Station Distribution. Many radio stations produce and
distribute commercials and short-form programming to other stations for airplay
on the same day, and the Company's network has proven efficient in delivering
this content, replacing ground deliveries and couriers. In addition,
consolidation in radio ownership has resulted in many of the new radio
mega-groups developing facilities for central audio production. The Company's
delivery system is used to distribute this production to the group's co-owned
stations.
Political Campaigns. Radio and television can provide a rapid response
mechanism for candidates and issue groups. The Company offers a same-day service
for the facilitation of such advertising during political campaigns. In 1998, an
election year, the Company delivered 25,000 campaign advertisements,
representing over 300 candidates and propositions.
Newspaper Headlines. Newspapers use the Company's services to deliver
topical radio commercials to run during the morning or afternoon in local
markets to encourage readership for local newspapers. The producer typically
reads a special early edition of the paper. Stories are selected on the basis of
topical content with the best chance of encouraging listeners to become readers.
The spot is written, recorded, mixed and transmitted to DG Systems for
distribution to local radio stations. Delivery guarantees are typically between
one and two hours depending on the market.
The Company also offers the following services:
Postproduction Services. Advertising agencies, advertisers,
corporations, and public relations firms often require additional services to be
performed before a produced element is distributed for broadcast purposes. In
addition to the Company's traditional postproduction services - closed
captioning, commercial tagging, international standards conversions, and
duplication - the Company has developed and introduced digital solutions in the
postproduction environment. The new digital services enforce the Company's focus
on a fully digital production and distribution environment.
Syndication Programming Distribution. Syndicators distribute long form
video programming inclusive of advertising to local television stations and
cable operators. The Company offers numerous postproduction services to prepare
this content for broadcast and distributes it across the country and around the
world. Distribution services include both satellite uplink and physical
duplication and shipping to those stations which do not or cannot receive the
content via satellite.
Corporate Duplication. Corporations and other entities develop
training, management communications and other general information programs for
internal and external distribution for various purposes. The Company provides
high volume duplication of such content on non-broadcast quality tape stock,
typically VHS.
SALES, MARKETING AND CUSTOMER SERVICE
Brand Strategy. The Company's brand strategy is to position itself as
the standard transaction method for the radio, television, cable, and network
broadcast industries. The Company focuses its marketing messages and programs at
multiple segments within the advertising and broadcast industries. Each of the
segments interacts with
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the Company for a different reason. Agencies purchase services from the Company
on behalf of their advertisers. Production studios facilitate the transmission
of audio and video to the Company's NOCs. Production studios and dub and ship
houses resell delivery services to agencies. Stations join the network to
receive the content from their customers, the agencies and advertisers. A key
strategy to providing a consistent brand theme at all levels is developing "DG"
as a brand identity across these various product and services offerings.
Internet/E-Commerce Strategy. The Company introduced its first
Internet-based services called DG On-line in 1998 to facilitate the electronic
remote entry of work orders and to provide on line tracking of order status by
its customers. In 1998, the Company estimates that 11% of its orders were
entered electronically via the Internet. In addition, the Company also offers
its "iAudio" Internet audio collection system service which allows audio content
to be received from clients via the Internet.
Sales. The Company employs a direct sales force that calls on various
departments at advertising agencies to communicate the capabilities and
comparative advantages of the Company's electronic distribution system and
related products and services. In addition, the Company's sales force calls on
corporate advertisers who are in a position to either direct or influence
agencies in directing deliveries to the Company. A separate staff sells to and
services audio and video dealers, who resale the Company's distribution
services. Lastly, an insider sales staff represents the Company's services to
radio stations. The Company currently has field sales offices in New York, Los
Angeles, Chicago and Vancouver (Canada), as well as sales personnel in its San
Francisco headquarters. The Company's sales force includes field sales, inside
sales, and telemarketing.
Marketing. The Company's marketing programs are directed toward demand
stimulation with an emphasis on popularizing the benefits of digital delivery,
including fast turnaround (same day services), increased flexibility, higher
quality, problem recovery, and greater reliability and accountability. These
marketing programs include direct mail and telemarketing campaigns, newsletters,
collateral material (including brochures, data sheets, etc.), application
stories, and corporate briefings in major U.S. cities. The Company also engages
in public relations activities including trade show participation, the
stimulation of articles in the trade and business press, press tours and
advertising in advertising and broadcast oriented trade publications.
The Company also markets to broadcast stations to arrange for the
placement of its RPTs and DVPSs for the receipt only of audio and video
advertisements, or Client Workstations, which provide the ability to both
receive and to originate distribution of audio to other radio stations. There is
currently no charge for a station to receive an advertisement. For radio
stations or groups that subscribe to network distribution services utilizing the
Client Workstation, the station signs a month-to-month, one-year, or two-year
term of service.
The Company believes that in combination with its acquisition of the
assets of DCI, its combined network provides digital distribution coverage for
more than 90% of commercial radio stations and distribution traffic in the
United States and Canada. The Company is focusing on the largest 100 television
markets as rated by A.C. Nielsen, along with the major cable interconnects and
cable and broadcast networks in the largest U.S. markets, and believes that its
network size has surpassed 70% coverage of the Company's targeted installation
size.
Customer Service. The Company's approach to customer service is based
on a distributed model designed to provide focused support from key market
centered offices, located in Los Angeles, San Francisco, Chicago, New York and
Vancouver. Clients work with specific, assigned account coordinators to place
production service and distribution orders. National distribution orders are
electronically routed to either the San Francisco or Vancouver NOC for
electronic distribution or, for offline destinations, to the Company's national
duplication center in Louisville, Kentucky. The Company's distributed service
approach provides direct support in the key market cities enabling the Company
to develop closer relationships with clients as well as the ability to support
client needs for local production services. The Company also maintains a
customer service team dedicated to supporting the needs of radio, television,
and network stations. This support is available 7 days a week, 24 hours a day,
to respond to station requests for information, traffic instructions or
additional media. Providing direct support alleviates the need for client
traffic departments to deal with individual stations or the challenges of
staffing for off-hours support. The Company's customer service operation centers
are linked to the Company's order management and media storage systems, and
national distribution network. These resources enable the Company to manage the
distribution of client orders to the fulfillment location best suited to meet
critical customer requirements as well as providing order status and fulfillment
confirmation. This distributed model also provides the Company with significant
redundancy and re-route capability, enabling the Company to meet customer needs
when weather or other conditions prevent deliveries using traditional courier
services.
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Work orders entered by customers into the CW are shipped automatically
through the NOCs to their destinations with minimal human intervention. No
monitoring is done of the spots, unless the Company is asked to review a spot by
a client. These capabilities enable the Company's customers to move to an
e-commerce business model as the service is developed more fully.
COMPETITION
The market for the distribution of advertising and other content to
radio and television stations and cable systems is highly competitive. The
Company currently competes in the market for the distribution of audio and video
advertising spots to broadcast stations, cable systems and networks. The
principal competitive factors affecting this market are ease of use, price,
timeliness and accuracy of delivery.
The Company competes with a variety of dub and ship houses and
production studios that have traditionally distributed taped advertising spots
via physical delivery. As local distributors, these entities have long-standing
ties with advertising agencies that are often difficult for the Company to
replace. In addition, these dub and ship houses and production studios often
provide an array of ancillary video services, including archival storage and
retrieval, closed captioning and format conversions, enabling them to deliver to
their advertiser and agency customers a full range of customizable, media
postproduction, preparation, distribution and trafficking services. The
Company's acquisitions of Mediatech and PDR enable the Company to provide
similar services in the three largest domestic advertising markets: New York,
Los Angeles and Chicago. The Company plans to continue pursuing potential dub
and ship house partners where such partnerships make strategic sense.
With the acquisition of DCI, the Company has the only widely deployed
electronic system for the delivery of audio advertisements; consequently, it
competes largely with physical tape duplication and shipping for audio
advertising distribution.
In the video marketplace, the Company also competes with dub and ship
houses across the country but additionally with a satellite-based real-time
video distribution network. This network differs from that of the Company in
several ways, including limited error checking, lack of digital video as the
standard output to the station and lack of a station server to support
presentation of video-on-demand to the station. The Company has been able to
successfully convince a number of customers of the relative benefits of its
system. The Company also anticipates that certain common and/or value-added
telecommunications carriers may develop and deploy high bandwidth network
services targeted at the advertising and broadcast industries, although none has
at this point entered the market for spot distribution.
To the extent that the Company is successful in entering new markets,
such as delivery of other content to radio and television stations or delivery
of data concerning the actual airtime and audience ratings of commercials, it
expects to face competition from companies in related communications markets
and/or package delivery markets which offer products and services with
functionality similar to that offered by the Company's products and services.
Telecommunications providers such as AT&T, MCI, and Regional Bell Operating
Companies could enter the market as competitors with significantly lower
telecommunications transportation costs. The Company also could face competition
from entities with package delivery expertise such as Federal Express, United
Parcel Service, DHL or Airborne if any such companies enter the electronic data
delivery market. Radio Networks such as ABC or Westwood One also could become
competitors by selling and transmitting advertisements separately from their
network content programming.
Many of the Company's current and potential competitors in the markets
for audio and video distribution have substantially greater financial,
technical, marketing and other resources and larger installed customer bases
than the Company. The Company expects that an increasingly competitive
environment may result in price reductions that could result in reduced unit
profit margins and loss of market share, all of which would have a material
adverse effect on the Company's business, results of operations and financial
condition. Moreover, the markets for the distribution of audio and video content
have become increasingly concentrated in recent years as a result of
acquisitions, which are likely to permit many of the Company's competitors to
devote significantly greater resources to the development and marketing of new
services. There can be no assurance that the Company will be able to compete
successfully with new or existing competitors or that competitive pressures
faced by the Company will not materially and adversely affect its business,
operating results and financial condition. See "Management's
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Discussion and Analysis of Financial Condition and Results of Operations Certain
Business Considerations - Competition."
The Company believes it has the broadest coverage in broadcast radio
and the largest market share by a wide margin.
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
The Company primarily relies upon a combination of copyright, trademark
and trade secret laws and license agreements to establish and protect
proprietary rights in its technologies. The source code for the Company's
software is protected both as a trade secret and as an unpublished copyrighted
work. Despite these precautions, it may be possible for a third party to copy or
otherwise obtain and use the Company's hardware, software or technology without
authorization or to develop similar technology independently. In addition,
effective copyright and trade secret protection may be unavailable or limited in
certain foreign countries.
Because the Company's business is characterized by rapid technological
change, the Company believes that factors such as the technological and creative
skills of its personnel, new computer hardware, software and telecommunications
developments, frequent hardware and software enhancements, name recognition, and
reliable customer service and support are more important to establishing and
maintaining a leadership position than the various legal protections of its
technology.
The Company believes that its software, trademarks and other
proprietary rights do not infringe the proprietary rights of third parties.
There can be no assurance, however, that third parties will not assert such
infringement by the Company with respect to current or future software, hardware
or services. Any such claims, with or without merit, could be time-consuming,
result in costly litigation, cause software release delays or might require the
Company to enter into royalty or licensing agreements. Such royalty or licensing
agreements, if required, may not be available on terms acceptable to the
Company.
EMPLOYEES
As of December 31, 1998, the Company had a total of 366
employees, including 27 in research and development, 35 in sales and marketing,
257 in operations and manufacturing, and 47 in finance and administration. Of
these employees, 314 were located in the United States and 52 were located in
Canada. None of the Company's employees are represented by a collective
bargaining agreement, and the Company has not experienced a work stoppage. The
Company considers its relations with its employees to be good.
The Company's business and prospects depend in significant part
upon the continued service of its key management, sales and marketing and
administrative personnel. The Company does not generally have employment
agreements with its key personnel. The loss of key management or technical
personnel could materially adversely affect the Company's business, operating
results and financial condition. The Company believes that its prospects depend
in large part upon its ability to attract and retain highly-skilled managerial,
sales and marketing and administrative personnel. Competition for such personnel
is intense, and there can be no assurance that the Company will be successful in
attracting and retaining such personnel. Failure to attract and retain key
personnel could have a material adverse effect on the Company's business,
operating results and financial condition. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations Certain Business
Considerations - Dependence on Key Personnel."
ITEM 2. PROPERTIES
The Company's headquarters are located at leased office space located
at 875 Battery Street in San Francisco, California. The Company's lease is for
15,000 square feet and expires in 2001. In order to sustain uninterrupted
network integrity, the Company has an agreement for non-interruptible access to
emergency power and the Company has arranged for alternative fiber optic routes
to maintain its fiber connection between its computers and its long distance
carrier. However, there can be no assurance that a catastrophic earthquake or
other natural disaster could not interrupt the company's operations. The Company
maintains a lease, set to expire in 2001, for a 5,000 square foot facility which
is used for assembly of its field equipment and for offsite storage. In
addition, the
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Company leases approximately 3,000 square feet in Louisville, Kentucky for its
dub and ship facility which expires in 2002; approximately 22,000 square feet in
New York City which is occupied by DG East (formerly PDR) and expires in 2006;
approximately 13,000 square feet in Los Angeles occupied by DG West (formerly
Mediatech) which expires in 2006; 30,500 square feet in Chicago, which is
occupied by DG Central (formerly Mediatech) on a month to month rental
agreement, pending finalization of a long-term lease; and 9,000 square feet
occupied by DG North (formerly DCI) in Burnaby, British Columbia (Vancouver,
Canada) which expires in December 1999. The Company believes that these
facilities and offices are adequate to meet its requirements for the foreseeable
future.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject to various legal proceedings and claims, either
asserted or unasserted, which arise in the ordinary course of business. While
the outcome of these claims cannot be predicted with certainty, management does
not believe that the outcome of any of these legal matters will have a material
effect on the Company's consolidated financial condition or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company did not submit any matters to a vote of security holders
during the fourth quarter of the fiscal year ended December 31, 1998.
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ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers and directors of the Company and their ages as
of December 31, 1998 are as follows:
NAME AGE TITLE(S)
--------------------------- --- -----------------------------------------------------
Scott K. Ginsburg 46 Chief Executive Officer and Chairman of the Board
Henry W. Donaldson 53 President, Chief Operating Officer and Director
Paul W. Emery II 57 Vice President of Finance and Chief Financial Officer
Robert H. Howard 49 Vice President of Direct Sales
Kirk C. Stirland 46 Vice President of Indirect Sales
Allan J. Kozak 49 Vice President of Marketing
Ernest V. Labbe 51 Vice President of Operations
Kevin R Compton (1) 40 Director
Jeffrey M. Drazan (2) 40 Director
Richard H. Harris (2) 69 Director
Lawrence D. Lenihan, Jr 34 Director
Leonard S. Matthews (1) (2) 76 Director
(1) Member of the Audit Committee
(2) Member of the Compensation Committee
Scott K. Ginsburg joined the Company in December 1998 as Chief
Executive Officer and Chairman of the Board. He is also the Chairman and Chief
Executive Officer of Starguide Digital Networks and most recently served as
Chief Executive Officer and Director of Chancellor Media Corporation. Mr.
Ginsburg also founded Evergreen Media Corporation in 1988, and was the
co-founder of Statewide Broadcasting, Inc. and H&G Communications, Inc. Mr.
Ginsburg earned a B.A. from George Washington University in 1974 and a J.D. from
the George Washington University Law Center in 1978.
Henry W. Donaldson joined the Company in March 1993, and from that date
until November 20, 1998 has served as its President and Chief Executive Officer
and as a member of the Company's Board of Directors. Since November 20, 1998 Mr.
Donaldson has served as President and Chief Operating Officer. He was formerly
President of the Data Communications Division of Rexel, Inc., a provider of
telecommunications and local area networking products and services, from
September 1989 through January 1993. Mr. Donaldson holds a B.A. in Mathematics
from Hamilton College.
Paul W. Emery, II, joined the Company in January, 1998 as Vice
President of Finance and Chief Financial Officer. He held the same title at
Inprise Corporation (Borland International), Megatest Corporation (prior to its
acquisition by Teradyne Corporation) and was Chief Executive Officer at System
Industries from 1989-1992. Mr. Emery holds a B.S. in Economics from the
University of Tennessee and an M.B.A. from the University of Maryland.
Robert H. Howard joined the Company in April 1997 as Vice President of
Sales, and now serves as Vice President of Direct Sales, focusing on the
Company's advertising and agency clients. Mr. Howard held several positions with
Columbine JDS, the world's leading provider of software to the broadcast
industry, from 1977 through 1996, including Vice President of Sales and
Marketing. Mr. Howard holds a B.A. in Communications and an MBA from the
University of Memphis.
Kirk C. Stirland joined the Company in October 1998 as part of the
acquisition of Digital Courier International, where he was Vice President of
Sales and Marketing. He has held sales and marketing positions with CBS Records
and MTV. More recently, he was Chief Operating Officer at Ceridian's Media
Marketing. Mr. Stirland holds a B.S. in Communications from Charter Oak State
College in Connecticut.
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Al Kozak joined the company in September 1998 as part of the
acquisition of Digital Courier International. Al Kozak was the founder,
President and Chief Operating Officer of Digital Courier International from 1994
until September 1998, when he became the Company's Vice President of Marketing.
From 1981 to 1994 he held various positions with MPR Teltech Ltd in Technical
Management and Marketing. Mr. Kozak holds a B.S. and an M.E. in Engineering from
the University of Alberta.
Ernest V. Labbe joined the company in January 1998 as Vice President of
Operations. Mr. Labbe has a long history in the communications industry, most
recently with Lucent Technologies as a General Manager with the Business
Communications Systems. Mr. Labbe holds a B.S. in Business Management from the
University of Rhode Island.
Kevin R. Compton has been a member of the Board of Directors of the
Company since March 1994. Mr. Compton has been a general partner of Kleiner,
Perkins, Caufield & Byers, a venture capital investment firm, since December
1990. Mr. Compton currently serves as a director of: Global Village
Communication, Inc., a networking hardware and software company; Citrix Systems,
a developer of server software; Corsair Communications, Inc., a developer of
hardware and software systems for the wireless telecommunications industry;
Verisign, a provider of digital authentication services; and on numerous
privately held companies. He holds a B.S. in Business Administration from the
University of Missouri.
Jeffrey M. Drazan has been a member of the Board of Directors of the
Company since July 1992. Mr. Drazan has been a general partner of Sierra
Ventures, a venture capital investment firm, since 1985. Mr. Drazan currently
serves as a director of FaxSav, Micromuse, and Retix, a telecommunications
equipment company. Mr. Drazan holds a B.S.E. in Engineering from Princeton and
an M.B.A. from New York University.
Richard H. Harris has been a member of the Board of Directors of the
Company since July 1992. Since July 1992, Mr. Harris has been President and
Owner of Harris Classical Broadcasting, operating two FM audio stations in
Milwaukee, Wisconsin. From May 1984 to May 1986, Mr. Harris was Chairman of the
Radio Advertising Bureau. From June 1964 to April 1991, Mr. Harris held various
senior management positions with Westinghouse Broadcasting Company, including
Chairman of the Radio Group. Mr. Harris holds a B.A. in Communications and
Economics from the University of Denver and is a graduate of the Advanced
Management Program at Harvard University.
Lawrence D. Lenihan, Jr. has been a member of the Board of Directors of
the Company since July 1997. Mr. Lenihan has been a managing member of the
General Partner for Pequot Private Equity Fund, L.P. since February 1997. He is
also a Principal at Pequot Capital Management, Inc. Mr. Lenihan was a Principal
at Broadview Associates, LLC, prior to joining Pequot Capital. He currently
serves as a Director of STM Wireless and Trikon Technologies. Mr. Lenihan holds
a B.S.E.E. from Duke University and an MBA from the Wharton School of Business.
Leonard S. Matthews has been a member of the Board of Directors of the
Company since April 1993. From January 1979 to January 1989, Mr. Matthews was
President and Chief Executive Officer of the American Association of Advertising
Agencies. Previously, Mr. Matthews had been president of two of the world's
leading advertising agencies, Leo Burnett and Young & Rubicam. From May 1992 to
the present, Mr. Matthews has been Chairman of the Board of Next Century Media,
an interactive television company. Mr. Matthews holds a B.S. in Business
Administration & Marketing from Northwestern University.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
The Common Stock of the Company has been traded on the Nasdaq National
Market under the symbol DGIT since the Company's initial public offering on
February 6, 1996. Prior to that time there was no public market for the
Company's Common Stock or other securities.
The following table sets forth the high and low closing sales prices of
our Common Stock from January 1, 1997 to December 31, 1998. Such prices
represent prices between dealers, do no include retail mark-ups, mark-downs or
commissions and may not represent actual transactions.
FISCAL YEAR ENDED 1998 FISCAL YEAR ENDED 1997
------------------------ ------------------------
HIGH LOW HIGH LOW
-------- -------- -------- --------
First Quarter .......... $ 5.13 $ 1.56 $ 8.38 $ 4.00
Second Quarter ......... 4.38 3.25 5.19 3.88
Third Quarter .......... 4.19 2.38 6.75 4.50
Fourth Quarter ......... 5.75 2.25 4.63 2.38
As of December 31, 1998, the Company had issued and outstanding
26,239,520 shares of its Common Stock. As of March 15, 1999, the Company had
issued and outstanding 26,529,744 shares of its Common Stock held by 141
shareholders of record. The Company estimates that there are approximately 1,300
beneficial shareholders.
On December 9, 1998, the Company sold and issued 3,843,212 shares of
Common Stock to certain other existing institutional and closely associated
investors, 2,920,134 of which were sold and issued pursuant to the terms of the
Common Stock Subscription Agreement dated September 29, 1998, at a price per
share of $2.74, and 923,078 of which were sold and issued pursuant to that
certain Common Stock and Warrant Subscription Agreement, dated December 9, 1998,
at a price per share of $3.25. In connection with this sale and issuance of
shares of the Company's Common Stock, the Company also issued warrants to
purchase up to 1,921,607 shares of Common Stock at an exercise price of $3.25.
The warrants are not exercisable for a minimum of one year, and, thereafter,
their exercisability is based on the performance of the Company's Common Stock.
The warrants expire in December 2001. The gross proceeds to the Company from the
sale and issuance of these additional shares of Common Stock and warrants to
purchase shares of Common Stock was approximately $11 million. In December 1998
a warrant to purchase up to 1,548,460 shares of the Company's Common Stock at an
exercise price of $3.25 was also issued in connection with the appointment of
the Company's new Chairman of the Board and Chief Executive Officer. This
warrant is not exercisable for a minimum of one year, and, thereafter, its
exercisability is based on the performance of the Company's Common Stock and the
continued service of the Company's Chief Executive Officer. The warrant expires
in December 2003. The offers and sales of the Common Stock and warrants to
purchase Common Stock were exempt from the registration requirements of the
Securities Act of 1933, as amended (the "Act"), pursuant to Section 4(2)
thereof. The Company relied on the following criteria to make such exemption
available: the number of offerees, the size and manner of the offering, the
sophistication of the offerees and the availability of material information.
The Company has never declared or paid cash dividends on its capital
stock. The Company currently expects to retain its future earnings for use in
the operation and expansion of its business and does not anticipate paying any
cash dividends in the foreseeable future.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations ---Certain Business Considerations Concentration of Stock
Ownership", "---Preferential Rights of Outstanding Preferred Stock" and
"---Possible Volatility of Share Price."
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ITEM 6. SELECTED FINANCIAL DATA
STATEMENTS OF OPERATIONS:
YEARS ENDED DECEMBER 31,
------------------------------------------------------------
1994 1995 1996 1997 1998
-------- -------- -------- -------- --------
(in thousands, except per share data)
Revenues ........................................ $ 2,432 $ 5,144 $ 10,523 $ 29,175 $ 41,270
-------- -------- -------- -------- --------
Costs and expenses:
Delivery and material costs ............... 953 1,810 3,084 11,334 14,630
Customer operations ....................... 1,886 2,974 4,164 11,388 14,780
Sales and marketing ....................... 2,248 3,406 3,998 4,417 4,970
Research and development .................. 1,048 1,590 2,092 2,473 2,780
General and administrative ................ 1,054 1,380 1,677 3,169 4,314
Write down of subsidiary (1) .............. -- -- -- -- 17,006
Depreciation and amortization ............. 913 2,345 4,331 9,306 10,266
-------- -------- -------- -------- --------
Total expenses ....................... 8,102 13,505 19,346 42,087 68,746
-------- -------- -------- -------- --------
Loss from operations ............................ (5,670) (8,361) (8,823) (12,912) (27,476)
-------- -------- -------- -------- --------
Other income (expense):
Interest income ........................... 129 417 1,422 744 243
Interest expense .......................... (71) (836) (1,726) (2,607) (3,014)
Gain from foreign exchange ................ -- -- -- -- 10
-------- -------- -------- -------- --------
Net Loss ........................................ $ (5,612) $ (8,780) $ (9,127) $(14,775) $(30,237)
======== ======== ======== ======== ========
Basic and diluted net loss per common share (2) . $ (8.23) $ (9.78) $ (.87) $ (2.52) $ (1.97)
======== ======== ======== ======== ========
Weighted average common shares .................. 682 898 10,488 11,893 16,272
======== ======== ======== ======== ========
(1) See Note 3 of Notes to Consolidated Financial Statements
(2) See Note 11 of Notes to Consolidated Financial Statements
BALANCE SHEET DATA:
YEARS ENDED DECEMBER 31,
------------------------------------------------------------
1994 1995 1996 1997 1998
-------- -------- -------- -------- --------
(in thousands)
Cash, cash equivalents and short-term investments $ 9,221 $ 6,205 $ 20,597 $ 8,820 $ 13,025
Working capital ................................. 8,755 4,651 14,200 (879) 7,179
Property and equipment, net ..................... 3,175 5,772 12,630 17,566 11,745
Total assets .................................... 13,572 14,459 45,248 60,697 49,792
Long-term debt, net of current portion .......... 1,573 4,540 8,495 11,847 9,307
Shareholders' equity ............................ 10,502 6,373 26,839 30,449 23,710
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The discussion in this Report contains forward-looking statements that
involve risks and uncertainties. The statements contained in this Report that
are not purely historical are forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. Words such as "anticipates,"
"believes," "plans," "expects," "future," "intends," and similar expressions are
used to identify forward-looking statements All forward-looking statements
included in this document are based on information available to the Company on
the date hereof, and we assume no obligation to update any such forward-looking
statements. The Company's actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including, but not limited to, those discussed in "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Certain Business
Considerations" as well as those discussed in this section and elsewhere in this
Report, and the risks discussed in the Company's other United States Securities
and Exchange Commission filings.
OVERVIEW
The Company was incorporated in 1991. Through 1993, the Company was a
development-stage company, principally engaged in developing its network,
marketing its services to radio stations and advertising agencies, and producing
and deploying terminals for use at advertising agencies, production studios and
radio stations. In 1994, the Company first generated significant operating
revenues from the delivery of audio commercials and the related text traffic
instructions to radio stations through a nationwide network established by the
Company. The Company has invested heavily in the development of its digital
audio network which was nearly complete by the end of 1996. It was at that time
that the Company began to promote its digital video technology service which
has been realizing positive growth since then. As the Company's audio and video
network coverage has expanded to include an increasing number of radio and
television stations, the number of deliveries ordered by customers has
increased. At the same time, the number of deliveries performed via electronic
delivery has increased relative to the number performed by physical delivery
through the Company's dub and ship facility in Louisville, Kentucky.
The Company defines a delivery as the transmission, electronic or
physical, of a piece or pieces of audio or video content, generally a commercial
("spot") or a set of commercials ("tied spots") to a destination, generally a
radio or television station, based on a single order from a customer. Each order
usually calls for the delivery of the same spot or spots to multiple
destinations, resulting in multiple deliveries. The revenue earned per delivery
is dependent upon the type of service ordered, generally defined by the time
interval between submission and delivery (Priority, Express, Standard or
Economy), the channel from which the order is received (directly from an
advertiser or advertising agency or through a dub and ship house), and the
quantity of audio or video being delivered (a single spot or multiple tied
spots.) DG Systems derives revenue from advertising agencies, as well as
production studios and dub and ship houses that consolidate and forward
deliveries for their agency customers. Because the revenue earned for the
delivery of the first spot is significantly greater than the revenue earned for
a tied spot and because the Company's per spot electronic transmission cost is
relatively constant regardless of volume, electronic deliveries that comprise a
single spot are generally more profitable than deliveries which include tied
spots. The Company recognizes revenue for each order on the date the content is
received by the destinations ordered.
The Company assembles, owns and maintains Receive Playback Terminals
("RPTs"), which are located in radio stations; Record Send Terminals ("RSTs"),
which are located in advertising agencies and production studios; Client
Workstations ("CWs") which are located in both radio stations and dealer
locations; Video Record Transmission Systems ("VRTSs"), which are located
primarily in production studios; and Digital Video Playback Systems ("DVPSs")
which are located in television stations. The capital required to build the
network has been obtained through various preferred stock offerings to
investors, primarily venture capital firms, leasing agreements, and the
Company's initial public offering, which was completed in February 1996.
In November 1996, the Company acquired 100% of the capital stock of PDR
Productions, Inc. ("PDR"), a New York City based media duplication and
distribution company. PDR's primary operations are services typical of the
traditional dub and ship house, including the physical duplication and
distribution of video content on a wide range of tape formats and performance of
a variety of audio and video editing services. The acquisition was
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accounted for as a purchase and the operating results of PDR have been included
in the consolidated results of the Company from the date of the closing of the
transaction, November 8, 1996.
In July 1997, the Company acquired 100% of the capital stock of Starcom
Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet, Inc.
("IndeNet") with operating facilities in Chicago, Los Angeles, New York and
Louisville. Mediatech's primary operations, similar to those of PDR, are also
services typical of a traditional dub and ship house. Although Mediatech's
revenues are generated primarily from the duplication and distribution of short
form content, consistent with those of DG Systems prior to this acquisition,
Mediatech's revenues also include a significant portion generated from the
distribution of long form syndicated programming of both live and previously
broadcast television shows. Such services include integrating commercials into
syndicated programs and uplinking the completed programs to satellites as well
as the physical duplication and distribution of such programs to those stations
which do not receive a satellite feed. The acquisition was accounted for as a
purchase and the operating results of Mediatech have been included in the
consolidated results of the Company from the date of the closing of the
transaction, July 18, 1997.
In September 1998, the Company acquired the assets of Digital Courier
International, Inc., ("DCI"), which has provided the Company with a Canadian
network for the delivery of radio advertisements, and two-way sending capability
in the US and Canadian market. In late 1998, the Company commenced plans to
integrate the acquired DCI assets with the Company's network with the
expectation of higher operating efficiencies. The acquisition was accounted for
as a purchase and the operating results and balance sheet of DCI have been
included in the consolidated results and balances of the Company from the date
of the closing of the transaction, September 25, 1998.
The Company acquired PDR, Mediatech and DCI with the expectation that
the acquisitions would result in enhanced efficiencies for the combined company,
including those resulting from the capability of providing digital delivery to
new customers and the capability of providing ancillary services to new and
existing customers in the markets served by PDR, Mediatech and DCI. See the
Notes to Consolidated Financial Statements and the Company's Current Report on
Form 8-K filed on October 13, 1998. See "Certain Business Considerations ---
Uncertainties Relating to Integration of Operations" and "--Dependence on Video
Advertising Service Deployment."
RESULTS OF OPERATIONS
The following presents the statements of operations of the Company
expressed as a percentage of total revenues and the related operating data for
the periods indicated.
YEARS ENDED DECEMBER 31,
---------------------------
STATEMENTS OF OPERATIONS: 1996 1997 1998
----- ----- -----
Revenues .............................. 100.0% 100.0% 100.0%
Cost and expenses:
Delivery and material costs ........... 29.3 38.8 35.4
Customer operations ................... 39.6 39.0 35.8
Sales and marketing ................... 38.0 15.1 12.0
Research and development .............. 19.9 8.5 6.7
General and administrative ............ 15.8 10.9 10.5
Write down of subsidiary .............. 0.0 0.0 41.2
Depreciation and amortization ......... 41.2 31.9 24.9
----- ----- -----
Total Expenses ........................ 183.8 144.2 166.5
----- ----- -----
Loss from operations .................. (83.8) (44.2) (66.5)
Other income expense):
Interest income ....................... 13.5 2.6 0.6
Interest expense ...................... (16.4) (8.9) (7.3)
----- ----- -----
Net loss .............................. (86.7)% (50.5)% (73.2)%
===== ===== =====
16
19
Revenues
YEARS ENDED DECEMBER 31,
-----------------------------
1996 1997 1998
------- ------- -------
Audio Distribution ................................ $ 9,588 $13,707 $18,984
Video Distribution ................................ 617 8,685 13,279
Ancillary Post-Production Services & Other Services 318 6,783 9,007
------- ------- -------
Total Revenues .................................... $10,523 $29,175 $41,270
======= ======= =======
Revenues increased from $10,523,000 to $29,175,000 to $41,270,000 for
the twelve months ended 1996, 1997 and 1998, respectively. This growth in
revenue is due primarily to increases of 53% in the combined volume of audio and
video deliveries performed in 1998 over 1997, and 72% increase in 1997 over
1996. Of the total volume increases in 1998 and 1997, 83% and 47%, respectively,
relate to orders delivered through the DG Systems Network Operating Center. The
Company believes that the increase in delivery volumes are due to a number of
factors, including the increased acceptance of the services offered by the
Company, the increased availability of the expanded network of Company equipment
located in radio and television stations, and the increased market presence
resulting from the September 1998 acquisition of DCI, the July 1997 acquisition
of Mediatech, and the November 1996 acquisition of PDR.
Average revenue per audio delivery decreased by approximately 8% in
1998 from 1997 and increased 7% in 1997 from 1996. These changes are due to
shifts in the mix of digital audio distribution services provided, i.e.,
Priority, Express, Standard and Economy, and to an increase in audio dealer
revenues in 1998 from 1997.
Average revenue per video delivery decreased by approximately 3% in
1998 from 1997 and increased 3% in 1997 from 1996. The decrease in average
revenue per delivery in 1998 from 1997 is due to changes in the mix of video
delivery services provided and the related customer pricing agreements resulting
from the acquisition of Mediatech.
In 1998, revenues from other services totaled approximately $9.0
million, a 33% increase versus revenue from these services in 1997 of
approximately $6.8 million provided by the former PDR and Mediatech facilities.
In 1998, this revenue consisted of $3.3 million of ancillary post-production
services, $2.8 million of corporate duplication, and $2.9 million of satellite
distribution services. Ancillary post-production services are generally related
to the preparation of video content for distribution. Corporate duplication
includes high volume replication of training or corporate and product
information tapes on non-broadcast quality tape stock, such as VHS. Satellite
services include the integration of commercials into syndicated programming and
uplinking the completed programs to satellites for distribution. The Company
will be de-emphasizing its efforts on the less profitable corporate duplication
and satellite distribution services in order to focus on its core audio, video
and ancillary post-production services.
Delivery and Material Costs
YEARS ENDED DECEMBER 31,
-----------------------------
1996 1997 1998
------- ------- -------
Audio Distribution $ 2,840 $ 3,750 $ 5,215
Video Distribution 191 4,536 5,910
Ancillary Post-Production Services & Other Services 53 3,048 3,505
------- ------- -------
Total Delivery and Material Costs $ 3,084 $11,334 $14,630
======= ======= =======
Delivery costs consist of fees paid to other service providers for
charges incurred by the Company in the receipt, transmission and delivery of
information via the Company's distribution network. Delivery expenditures have
principally been for the telephone and satellite transmission of deliveries
performed electronically and for the air freight incurred in the physical
delivery of tapes to locations not directly linked to the DG network operating
center. Delivery costs also include fees paid to secure satellite transmission
capabilities in connection with the services offered by the Company. Material
costs consist primarily of audio and videotape, the related packaging, and the
direct materials and supplies used in providing the various services offered by
the Company. Material costs are not generally required in the case of electronic
distribution.
17
20
Delivery and material costs were $3,084,000, $11,334,000, and
$14,630,000 in 1996, 1997 and 1998, respectively. In 1997, delivery and material
costs increased significantly as a result of increased electronic and physical
delivery volume, particularly video deliveries made directly from the former PDR
and Mediatech facilities, as well as the addition of the direct costs related to
the other services now provided by the Company as a result of the PDR and
Mediatech acquisitions. These increased costs include both delivery expenses and
direct materials costs required when physically duplicating and distributing a
video or audio spot as well as the direct materials and fees paid to other
services providers in connection with ancillary post-production services and
other services offered by the Company. In 1998, delivery and material costs
increased as a result of continuing increases in delivery volumes as well as the
addition of direct costs as a result of the acquisition of DCI.
Delivery and material costs as a percentage of revenues increased from
29% in 1996 to 39% in 1997 and decreased to 35% in 1998. The increase in such
costs as a percentage of total revenues from 1996 to 1997 is due to the change
in mix of services offered by the Company as a result of the acquisitions and
the ramp up and concomitant fixed costs of the electronic video distribution
service. The Company's audio distribution services primarily are performed
electronically, which has resulted in lower delivery and material costs as a
percentage of revenues than those of the Company's video distribution and other
service offerings. In 1998, the decrease in delivery and material costs as a
percentage of revenues is due principally to the improvements in electronic
costs of delivery for audio and video distribution as volumes have increased.
Audio distribution delivery and material costs as a percentage of audio
revenues decreased to approximately 27% in 1998 and 1997 from 30% in 1996. These
decreases are primarily the result of improvements in cost per electronic
delivery resulting from the increased volume of electronic audio deliveries,
which has resulted in greater efficiencies. In addition, the Company renewed its
contract with its primary telephone service provider in May 1997 that resulted
in improvements in cost per electronic delivery.
Video delivery and material costs as a percentage of video revenues
decreased to approximately 45% in 1998 from 52% in 1997, due primarily to an
increase in the volume of deliveries performed and improvements of the cost of
video deliveries being fulfilled through the San Francisco NOC. During 1997, the
Company began volume electronic video delivery, continued to add television
stations to its network and developed network communications links between the
San Francisco NOC and the acquired facilities in New York, Chicago and Los
Angeles. Consequently, the number of stations capable of receiving electronic
delivery and the number of orders received at the acquired facilities that were
capable of being delivered via the San Francisco NOC increased over the course
of 1997 and 1998. In addition, the Company also incurs video delivery and
material costs from the physical duplication and distribution of tapes directly
from the acquired facilities and from the Company's dub and ship facility in
Louisville, Kentucky.
Delivery and material costs related to the other services provided by
the Company were 39% of associated revenues in 1998 and 45% in 1997. The direct
costs as a percentage of revenues associated with these services vary widely
based on the numerous services performed and the rates negotiated with the
customers using these services. In general, the direct costs of corporate
duplication and satellite services have higher costs as a percentage of revenues
than the Company's audio and video distribution services.
The Company expects that delivery costs will increase in absolute
dollars and may fluctuate as a percentage of revenues in future periods,
influenced principally by volumes, average sales price and scale economies as
video deliveries increase in volume. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations ---", "Certain Business
Considerations ---Uncertainties Relating to Integration of Operations,"
"---Ability to Manage Growth," "---Dependence on Certain Suppliers" and
"---Potential Fluctuations in Quarterly Results; Seasonality."
Customer Operations
Customer operations expenses consist primarily of salaries and the
related overhead costs incurred in performing deliveries and providing services,
including order entry, customer service and assembly and maintenance of network
equipment including the Company's RPTs, RSTs, CWs, VRTSs, DVPSs, tape dubbing
and editing equipment, and the NOCs.
18
21
Customer operations expenses were $4,164,000, $11,388,000 and
$14,780,000 in 1996, 1997 and 1998, respectively. The increase in expenses in
1998 versus 1997 is due primarily to increased costs incurred to support the
greater volume of deliveries processed through the Company's San Francisco NOC
as well as the consolidation of the costs of the former Mediatech and DCI
operations. The increase in expenses in 1997 versus 1996 is primarily the result
of the consolidation of the costs of the former PDR and Mediatech facilities. In
addition, these expenses increased in 1997 and 1998 due to the addition of the
personnel necessary to establish the operational capacity to support growth in
the electronic video delivery business. These additional expenses include the
costs, primarily labor expenses, of personnel involved in assembly of the DVPSs
as well as customer and technical support.
Customer operations expenses as a percentage of revenues has decreased
from 40% to 39% to 36% in 1996, 1997 and 1998, respectively. In 1998, the
Company reduced customer operations expenses as a percentage of revenues to 30%
from approximately 35% in 1997 for orders processed through the San Francisco
NOC, which serves as the primary support for the digital network. These
improvements in cost as a percentage of revenues, however, were generally offset
by the impact of the relatively more expensive customer operations expenses of
the former PDR, Mediatech and DCI facilities, which have a different cost
structure in order to provide the additional services offered at these
locations.
The Company expects that customer operations expenses will increase in
absolute dollars and may fluctuate as a percentage of revenues in future
periods. Moreover, the Company believes that in order to compete effectively and
manage future growth, the Company will be required to continue to implement
changes that improve and increase the efficiency of its customer operations. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations ---", "Certain Business Considerations -- Ability to Maintain and
Improve Service Quality" and "-- Ability to Manage Growth."
Sales and Marketing
Sales and marketing expenses include salaries, incentive compensation,
professional fees and the related overhead costs incurred in promoting,
marketing and selling the Company and its services to customers and radio and
television stations. Sales and marketing expenses were $3,998,000, $4,417,000
and $4,970,000 in 1996, 1997 and 1998, respectively. These increases were the
result of additional costs incurred in introducing the Company's service to the
marketplace, including the salaries of expanded sales and marketing forces,
increased incentive compensation resulting from increased revenues and increased
marketing program activity. The increase in expenses in 1997 versus 1996 is due
primarily to the consolidation of the costs of the former Mediatech and PDR
sales groups. During 1997, the Company's sales forces were united under the
direction of the DG Systems' Vice President of Sales in order to more
effectively and efficiently market the Company's complete set of services
throughout the country. The increase in expenses in 1998 versus 1997 is due
primarily to growth in marketing program costs to increase customer awareness of
the Company's services. In addition, sales and marketing expenses increased due
to the acquisition of DCI. Sales and marketing costs as a percentage of revenue,
however, has decreased from 38% to 15% to 12% of revenues for 1996, 1997 and
1998, respectively.
The Company expects to continue to expand sales and marketing programs
designed to introduce the Company's services to the marketplace and to attract
new customers for its services. The Company expects that sales and marketing
expenses will increase in absolute dollars in future periods and may fluctuate
as a percentage of revenue in future periods. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations ---", "Certain
Business Considerations -- Dependence on Emerging Markets."
Research and Development
Research and development expenses consist primarily of salaries,
recruiting, consulting fees, and the related overhead incurred in the
development and enhancement of the delivery system used to distribute
information via the DG Systems' network. Research and development costs are
expensed as incurred until technological feasibility is established, after which
any additional costs are capitalized, in accordance with Statement of Financial
Accounting Standards No. 86, "Accounting for the Costs of Computer Software to
be sold, Leased or Otherwise Marketed." To date, no software development costs
have been capitalized by the Company as the capitalizable amounts have been
immaterial. Research and development expenses were $2,092,000, $2,473,000 and
$2,780,000 in 1996, 1997 and 1998, respectively. Research and development
expenses have increased 33% from 1996 through 1998 primarily due to the hiring
of additional engineers to develop and enhance the Company's digital services.
Research and development expenses in 1998 also increased due to the additional
research and development expenses incurred as a
19
22
result of its acquisition of DCI. These costs more than offset reductions in
development and testing costs, principally frame relay and satellite
transmissions, associated with preparing the delivery system for the
transmission of video content through the San Francisco NOC. As a percent of
revenues, research and development expenses have decreased from 20% in 1996 to
9% in 1997 to 7% in 1998.
The Company expects that increased research and development expenses
will be necessary to remain competitive and that its future success will depend
in significant part upon the technological quality of its products and processes
relative to those of its competitors and its ability both to develop new and
enhanced products and services. The Company's research and development expenses
may increase substantially in absolute dollars and may fluctuate as a percentage
of revenues in future periods.
General and Administrative
General and administrative expenses consist primarily of personnel,
consulting fees, and related overhead costs for finance and general management
of the Company. General and administrative expenses were $1,677,000 $3,169,000
and $4,314,000 in 1996, 1997 and 1998, respectively. These increases were
primarily due to the costs incurred to consolidate and upgrade the Company's
order entry, billing and financial reporting systems and the increase in staff
both as a result of the acquisitions of Mediatech and DCI. Although general and
administrative expenses have increased in absolute dollars, these expenses as a
percentage of revenues have decreased from 16% in 1996 to 11% in both 1997 and
1998. The Company expects that general and administrative expenses will increase
in absolute dollars and may fluctuate as a percentage of revenues in future
periods.
Depreciation and Amortization
Depreciation and amortization expenses are attributable primarily to
the Company's distribution network, including RPTs, RSTs, CWs, DVPSs, VRTSs,
video dubbing and editing equipment and the NOC equipment. These assets are
expensed over their estimated useful lives, generally three years. Depreciation
and amortization expense was $4,331,000, $9,306,000 and $10,266,000 in 1996,
1997 and 1998, respectively. These increases were due to the continued expansion
of the Company's network. The Company's total investment in network equipment
has increased from $18.0 million to $30.4 million to $33.2 million at the end of
1996, 1997 and 1998, respectively. In particular, the Company made equipment
additions of $4.7 million and $1.3 million in 1997 and 1998, respectively, to
support its video delivery service plan and has increased the number of units
located at broadcast stations at December 31, 1998. The Company owns
approximately $7.7 million and $1.1 million of network equipment in connection
with the acquisitions of Mediatech and DCI, respectively.
The Company recorded amortization expense of $71,000, $787,000 and
$1,163,000 in 1996, 1997, and 1998, respectively, related to the goodwill and
other intangible assets recorded in connection with the acquisitions of PDR
Mediatech, and DCI. As discussed in the Notes to the Condensed Consolidated
Financial Statements, in September 1998, the Company wrote down the remaining
goodwill of its Mediatech subsidiary, approximately $16.7 million, and wrote
down Mediatech's fixed assets by an additional $340,000 because it was
determined that the carrying values of these assets may not be recoverable.
Because of a change in Mediatech's business, it was determined that the value of
the investment had permanently declined. The fair value of the Mediatech assets
was determined by discounting the related expected future cash flows over the
remaining life of the goodwill amortization period of 19 years.
The Company expects to continue to invest in the expansion of its
network. In particular, the Company is in the process of expanding its
infrastructure within the television broadcast industry that will require
additional VRTSs and DVPSs to be built and installed in production studios and
television stations. The Company expects depreciation and amortization to
increase in absolute dollars in proportion to this growth. However, there can be
no assurance that the Company will make such investments or that such
investments will result in future revenue growth. See "Management's Discussion
and Analysis of Financial Position and Results of Operations ---", "Certain
Business Considerations -- Future Capital Needs; Uncertainty of Additional
Funding."
Interest Income and Interest Expense
The Company has derived interest income from the short-term investment
of the proceeds received in various preferred stock offerings, including $23.7
million of net proceeds from the private placements of Common Stock in August
and December 1998; $16.4 million of net proceeds from the Series A Convertible
Preferred Stock offering in
20
23
July 1997, and from the investment of the $29.5 million of net proceeds from its
initial public offering in February 1996. Interest income was $1,422,000,
$744,000 and $243,000 in 1996, 1997 and 1998, respectively. The fluctuations in
interest income were due to differences in the amounts raised and the timing of
each offering as well as the differences in the levels of cash used to fund
Company operations and strategic acquisitions. The Company expects that interest
income will decrease in the future in proportion to the levels of cash used to
fund operations and acquisition activity. See "Management's Discussion and
Analysis of Financial Position and Results of Operations ---", "Liquidity and
Capital Resources."
Interest expense incurred by the Company was $1,726,000, $2,607,000 and
$3,014,000 in 1996, 1997 and 1998, respectively. This expense has been due
primarily to lease agreements used to fund the acquisition of components and
equipment needed to develop the network and to provide Company personnel with
the capital resources necessary to support the Company's business growth. Debt
outstanding under these agreements has increased from $12.2 million to $13.8
million and decreased to $13.5 million at the end of 1996, 1997 and 1998,
respectively. In addition, during 1998 the Company incurred additional interest
expense totaling $253,000 on the promissory notes given as consideration in the
acquisitions of Mediatech and incurred $397,000 of interest expense on the term
debt and line of credit assumed in conjunction with the Mediatech acquisition.
The Company expects interest expense will increase in the future based on the
increased levels of borrowing. See "Management's Discussion and Analysis of
Financial Position and Results of Operations ---", "Liquidity and Capital
Resources."
QUARTERLY RESULTS OF OPERATIONS
The following table presents unaudited quarterly statements of
operations for the Company. The information has been prepared by the Company on
a basis consistent with the Company's audited financial statements and includes
all adjustments, consisting of only normal recurring adjustments that management
considers necessary for a fair presentation of the information for the periods
presented. The Company's quarterly operating results have in the past and may in
the future vary significantly depending on factors such as the volume of
advertising in response to seasonal buying patterns, the timing of new product
and service introductions, increased competition, the timing of the Company's
promotional efforts, general economic factors, and other factors. For example,
the Company has historically experienced lower sales in the first quarter and
higher sales in the fourth quarter, due to increased customer advertising
volumes for the November television sweeps rating period and Christmas selling
season. As a result, the Company believes that period to period comparisons of
its results are not necessarily meaningful and should not be relied upon as an
indication of future performance.
21
24
THREE MONTHS ENDED
---------------------------------------------------------------------
MARCH 31, JUNE 30, SEPT. 30, DEC. 31,
1997 1997 1997 1997
-------- -------- -------- --------
STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT OPERATING DATA)
Revenues ...................................... $ 4,606 $ 5,405 8,798 $ 10,366
-------- -------- -------- --------
Costs and expenses:
Delivery and material costs ............... 1,475 1,813 3,886 4,160
Customer operations ....................... 2,135 2,104 3,241 3,908
Sales and marketing ....................... 1,015 1,126 1,232 1,045
Research and development .................. 648 620 688 517
General and administrative ................ 604 637 998 930
Write down of subsidiary .................. -- -- -- --
Depreciation and amortization ............. 1,765 1,968 2,628 2,945
-------- -------- -------- --------
Total expenses ........................ 7,642 8,268 12,673 13,504
-------- -------- -------- --------
Loss from operations .......................... (3,036) (2,863) (3,875) (3,138)
Other income (expense):
Interest income ........................... 251 215 138 140
Interest expense .......................... (511) (553) (762) (781)
Foreign exchange gain (loss) .............. -- -- -- --
-------- -------- -------- --------
Net loss ...................................... $ (3,296) $ (3,201) $ (4,499) $ (3,779)
======== ======== ======== ========
Basic and diluted net loss per common share (1) $ (0.28) $ (0.27) $ (1.63) $ (0.31)
======== ======== ======== ========
Weighted average common shares ................ 11,686 11,733 12,035 12,118
======== ======== ======== ========
THREE MONTHS ENDED
--------------------------------------------------------------------
MARCH 31, JUNE 30, SEPT. 30, DEC. 31,
1998 1998 1998 1998
-------- -------- -------- --------
STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT OPERATING DATA)
Revenues ...................................... $ 9,874 $ 10,097 $ 9,021 $ 12,278
-------- -------- -------- --------
Costs and expenses:
Delivery and material costs ............... 3,746 3,666 3,250 3,968
Customer operations ....................... 3,575 3,468 3,460 4,277
Sales and marketing ....................... 1,264 1,235 1,156 1,315
Research and development .................. 588 601 795 796
General and administrative ................ 1,029 1,015 1,097 1,173
Write down of subsidiary .................. -- -- 17,006 --
Depreciation and amortization ............. 2,833 2,880 2,914 1,639
-------- -------- -------- --------
Total expenses ........................ 13,035 12,865 29,678 13,168
-------- -------- -------- --------
Loss from operations .......................... (3,161) (2,768) (20,657) (890)
Other income (expense):
Interest income ........................... 69 45 63 66
Interest expense .......................... (711) (696) (831) (776)
Foreign exchange gain (loss) .............. -- -- -- 10
-------- -------- -------- --------
Net loss ...................................... $ (3,803) $ (3,419) $(21,425) $ (1,590)
======== ======== ======== ========
Basic and diluted net loss per common share (1) $ (0.31) $ (0.28) $ (1.33) $ (0.07)
======== ======== ======== ========
Weighted average common shares ................ 12,176 12,216 17,471 23,277
======== ======== ======== ========
(1) See Note 11 to Consolidated Financial Statements
LIQUIDITY AND CAPITAL RESOURCES
From its inception through December 31, 1995, the Company financed its
operations and met its capital expenditure requirements primarily from the
proceeds of private sales of Preferred Stock and Common Stock and through
capital lease agreements. Through December 31, 1995, the Company had raised
$25.5 million from the sale of Preferred Stock and Common Stock and had funded
$7.6 million of capital expenditures with long-term lease agreements. In 1996,
the Company raised $29.6 million from the sale of Common Stock, primarily
through it's initial public offering, and an additional $8.0 million of capital
equipment was funded through capital lease agreements. In 1997, the Company
raised $16.4 million from sale of Series A Convertible Preferred Stock and
funded $5.8 million of capital equipment through long-term credit facilities. In
1998, the Company received net proceeds of approximately $23.7 million from the
sale of Common Stock through private placements effected in August and December
1998.
At December 31, 1998, the Company's current sources of liquidity
included cash and cash equivalents of $13.0 million. Mediatech, a wholly owned
subsidiary, has a revolving line of credit available to fund the working capital
requirements of Mediatech. The maximum available under the Mediatech line is
$3,525,000, dependent upon the level of qualifying receivables maintained by
Mediatech; the balance outstanding at December 31, 1998 is $1,433,000, which is
approximately equal to the maximum available under the agreement at that time.
The Company expects to fully utilize the funding available under the existing
credit agreements.
The Company used cash of $4.3 million, $6.3 million and $5.0 million in
1996, 1997 and 1998, respectively, from operating activities. Net cash used in
operating activities exclusive of the write-down of its subsidiary improved
during 1998 as compared to 1997. This improvement was primarily due to a 42%
increase in revenue in 1998 as compared to 1997, while operating expense, less
the write-down of its subsidiary, increased 23% during 1998 over 1997.
Additionally, the Company's accounts receivable balance, net of reserves
increased 24% from 1997; however, revenues increased 42% in 1998 over 1997,
reflecting an improvement in cash collections in 1998 over the prior year. Net
cash used in operating activities increased in 1997 versus 1996, primarily
because net interest expense increased by $1.6 million and offset improved
operating results. The Company's net earnings before interest, taxes and
depreciation has improved from a loss of $4.5 million in 1996, to
22
25
a loss of $3.6 million in 1997, to a loss of $203,000 in 1998. In addition,
changes in working capital, principally payments on accounts payable and accrued
liabilities, used $3.0 million of cash in 1998.
The Company used $2.4 million, $5.1 million and $2.2 million of cash in
1996, 1997 and 1998, respectively, to purchase property and equipment. In
addition, $8.0 million, $0.4 million and $1.7 million of property and equipment
has been acquired through term lease or credit agreements in 1996, 1997 and
1998, respectively. The capital additions for each of the three years were a
result of the Company's continued expansion of its network. In particular,
capital additions in 1996 and 1997 were primarily in support its video delivery
service plan.
The Company completed its initial public offering in February 1996. The
net proceeds to the Company in 1996 after underwriting discounts and offering
expenses were $29.5 million. The Company raised $16.4 million, net of offering
expenses, through its Series A Convertible Preferred Stock offering in 1997. The
proceeds from these two offerings have been used in the acquisitions of PDR in
November 1996 and Mediatech in July 1997, as well as to fund the acquisition of
property and equipment, the payment of lease obligations and to fund the
continuing operations of the Company. Approximately $20.5 million has been
invested in the purchases of PDR and Mediatech and an additional $2.5 million
was used to repay the promissory note payable in November 1997 as a result of
the PDR acquisition. In connection with the July 1997 acquisition of Mediatech,
the Company also issued 324,355 shares of the Company's Common Stock, $3.8
million of promissory notes, and assumed $5.4 million of term and line of credit
debt payable by Mediatech. In August 1998, the Company raised approximately
$12.7 million from a private placement of 4.6 million shares of Common Stock and
in December 1998 raised approximately $11.0 million from a private placement of
3.8 million shares of Common Stock. The proceeds from these two offerings were
used to fund the purchase of DCI in September 1998, as well as to fund the
purchase of property and equipment, payment of lease obligations and to fund the
continuing operations of the Company. As of December 31, 1998, the remaining
$13.0 million of the net proceeds of the offerings were invested in short-term
investments and cash and cash equivalents. See the Notes to the Financial
Statements.
The Company, through its Mediatech subsidiary, made net payments on the
Mediatech line of credit of $1,402,000 in 1998. As mentioned above, the maximum
available under the Mediatech line is $3,525,000, dependent upon the level of
qualifying receivables maintained by Mediatech and the balance outstanding on
the line of credit at December 31, 1998 was $1,433,000, which was approximately
equal to the maximum available under the agreement at that time.
Principal payments on long-term debt were $2.1 million, $8.0 million
and $7.1 million in 1996, 1997 and 1998, respectively, reflecting the increases
in regularly scheduled repayment of the increased capital lease liability
incurred to finance equipment and property acquisitions. Principal payments in
1997 also included the following scheduled payments: repayment of a $2.5 million
promissory note issued in connection with the PDR acquisition, $500,000 of
payments on the promissory notes issued in connection with the Mediatech
acquisition and $346,000 of payments on other long-term debt of Mediatech
assumed by the Company in conjunction with the Mediatech acquisition.
The Company currently has no significant capital commitments other than
the commitments under capital leases and the debt assumed and notes payable
issued in conjunction with the purchase of Mediatech. Based on management's
current plans and forecasts, the Company believes that its existing sources of
liquidity will satisfy the Company's projected working capital, capital lease
and term loan commitments and other cash requirements through the fourth quarter
of 1999. To provide additional flexibility for growth and other general
corporate purposes, however, the Company plans to raise additional capital in
1999. See "Certain Business Considerations -- Future Capital Needs; Uncertainty
of Additional Funding."
CERTAIN BUSINESS CONSIDERATIONS
The Company's business is subject to the following risks in addition to
those described elsewhere in this Report.
23
26
HISTORY OF LOSSES; FUTURE OPERATING RESULTS UNCERTAIN
DG Systems was founded in 1991 and has been unprofitable since its
inception. The Company expects to continue to generate net losses for much of
the next twelve months. As of December 31, 1998, the accumulated deficit was
$90.1 million. Although the Company has recently experienced significant growth,
a significant portion of such growth is due to acquisitions. In addition, such
growth rates may not be sustainable and such growth rates should not be used as
an indication of future sales growth, if any, or as an indication of future
operating results. The Company's future success also depends in part on
obtaining continued reductions in delivery and service costs, particularly its
ability to continue to automate order processing and to reduce
telecommunications costs. As a result of the foregoing factors, there can be no
assurance that the Company's sales will grow or that the Company's sales will be
sustained in future periods. In addition, there can be no assurance that the
Company will be able to reduce delivery and service costs, or that it will
achieve or sustain profitability in any future period.
DEPENDENCE ON ELECTRONIC VIDEO ADVERTISING DELIVERY SERVICE DEPLOYMENT
The Company has made a substantial investment in upgrading and
expanding its NOC in San Francisco, and in populating television stations with
the units necessary for the receipt of electronically delivered video
advertising content. However the Company cannot assure that the placement of
these units will cause this service to achieve adequate market acceptance among
customers that require video advertising content delivery. The Company's
inability to place units in an adequate number of stations or its inability to
capture market share among content delivery customers which may be the result of
price competition, new product introductions from competitors or otherwise,
would seriously harm the Company's business, operating results and financial
position.
In addition, the Company believes that in order to more fully address
the needs of potential video delivery customers it will need to develop a set of
ancillary services that typically are provided by dub and ship houses. These
ancillary services include physical archiving, closed captioning, modification
of slates and format conversions. Such services will need to be provided on a
localized basis in each of the major cities in which the Company provide
services directly to agencies and advertisers. The Company currently has the
capability to provide such services through its facilities in New York, Los
Angeles and Chicago. However, it cannot assure that it will be able to
successfully contract for and provide these services in each or any major
metropolitan area or that it will be able to provide competitive video
distribution services in other U.S. markets. Also, although the Company is
taking the steps required to achieve the network capacity and scalability
necessary to deliver video content reliably and cost effectively as video
advertising delivery volume grows, the Company cannot assure that it will
achieve such goals and its failure to do so may seriously harm its business,
operating results and financial position. In addition, the Company may be unable
to retain current audio delivery customers or attract future audio delivery
customers who may ultimately demand delivery of both media content unless it can
successfully continue to develop and provide video transmission services. The
failure to retain such customers could seriously harm its results of operations
and financial condition.
ABILITY TO MAINTAIN AND IMPROVE SERVICE QUALITY
The Company's business is dependent on its ability to make
cost-effective deliveries to broadcast stations within the time periods
requested by customers. Any failure to do so, whether or not within our control,
could result in an advertisement not being run and in the station losing
air-time which it could have otherwise sold. Although the Company disclaims any
liability for lost air-time, claims by stations for lost air-time may
nevertheless be asserted in these circumstances and dissatisfied advertisers may
refuse to make further deliveries through DG Systems in the event of a
significant occurrence of lost deliveries, which would seriously harm its
business, financial condition and results of operations. Although the Company
maintains insurance against business interruption, such insurance may not be
adequate to protect it from significant loss in these circumstances or from the
effects of a major catastrophe (such as an earthquake or other natural disaster)
which could result in a prolonged interruption of its business. In particular,
one of its NOCs is located in the San Francisco Bay area, which has in the past,
and may in the future experience significant, destructive seismic activity that
could damage or destroy the NOC. In addition, the Company's ability to make
deliveries to stations within the time periods requested by customers depends on
a number of factors, some of which are outside of its control, including:
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o Equipment failure;
o Interruption in services by telecommunications service
providers; and
o The inability to maintain our installed base of RSTs, RPTs,
CWs, VRTSs and DVPS units that comprise its distribution
network.
Failure to make timely deliveries for whatever reason could result in
dissatisfied advertisers refusing to make further deliveries through DG Systems
which would seriously harm its business, financial condition and results of
operations.
DEPENDENCE ON EMERGING MARKETS
The market for the electronic delivery of digital audio and video
transmissions by advertisers, advertising agencies, production studios, and
video and music distributors to radio and television stations, is relatively
new, and alternative technologies are rapidly evolving. The Company's marketing
task requires it to overcome buyer inertia related to the diffuse and relatively
low level decision making regarding an agency's choice of delivery services and
long standing relationships with existing dub and ship vendors. Therefore, it is
difficult to predict the rate at which the market for the electronic delivery of
digital audio and video transmissions will grow, if such market grows at all. If
the market fails to grow, or grows more slowly than anticipated, our business,
operating results and financial condition would be seriously harmed. Even if the
market does grow, it cannot assure that its products and services will achieve
commercial success. Although the Company intends to conform its products and
services to meet existing and emerging standards in the market for the
electronic delivery of digital audio and video transmissions, it cannot assure
that it will be able to conform its products to such standards in a timely
fashion, or that it will be able to conform its products to such standards at
all. The Company believes that its future growth will depend, in part, on its
ability to add these services and additional customers in a timely and
cost-effective manner. However, it cannot assure that it will be successful in
developing such services, or in obtaining new customers for such services. See
"Dependence on New Product Introductions." Furthermore, it cannot assure that it
will be successful in obtaining a sufficient number of radio and television
stations, radio and television networks, advertisers, advertising agencies,
production studios, and audio and video distributors who are willing to bear the
costs of expanding and increasing the integration of its network, including its
field receiving equipment and rooftop satellite antennae.
The Company's marketing efforts to date with regard to its products and
services have involved identification and characterization of specific market
segments for these products and services with a view to determining the target
markets that will be the most receptive to such products and services. The
Company cannot assure that it has correctly identified such markets or that its
planned products and services will address the needs of such markets.
Furthermore, it cannot assure that its technologies, in their current form, will
be suitable for specific applications or that further design modifications,
beyond anticipated changes to accommodate different markets, will not be
necessary. Broad commercialization of its products and services will require it
to overcome significant market development hurdles, many of which may not
currently be foreseen.
UNCERTAINTIES RELATING TO INTEGRATION OF OPERATIONS
The Company effected the recent acquisitions of PDR, Mediatech, and
DCI, with the expectation that such strategic acquisitions would result in
enhanced efficiencies for the combined company. To date the Company has not
fully completed the integration of PDR, Mediatech or DCI with DG Systems.
Achieving the anticipated benefits of these acquisitions will depend in part
upon whether the integration of the organizations and businesses of PDR,
Mediatech and DCI with those of DG Systems is achieved in an efficient,
effective and timely manner. However, the Company cannot assure that such
integration will occur. The successful integration and expansion of its business
following its acquisition of PDR, Mediatech and DCI requires communication and
cooperation among the senior executives and key technical personnel of DG
Systems, PDR, Mediatech and DCI. Given the inherent difficulties involved in
completing a business combination, the Company cannot assure that such
cooperation will occur or that the integration of the respective organizations
will be successful and will not result in disruptions in one or more sectors of
its business. The failure to effectively accomplish the integration of the
operations of PDR, Mediatech and DCI with those of DG Systems could seriously
harm its results of operations and financial condition. In addition, the Company
cannot assure that all of its current and potential customers will favorably
view its services as offered through PDR, Mediatech and DCI or that it will
realize any of the other anticipated benefits of the acquisitions. Moreover, as
a result of these acquisitions, certain of its customers may perceive PDR,
Mediatech or
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DCI to be a competitor, and this could affect such customers' willingness to do
business with the Company in the future. The loss of significant customers would
seriously harm its results of operations and financial condition.
FUTURE CAPITAL NEEDS; UNCERTAINTY OF ADDITIONAL FUNDING
The Company intends to continue making capital expenditures to produce
and install RSTs, RPTs, CWs, VRTSs, and DVPS units and to introduce additional
services. In addition, it continually analyzes the costs and benefits of
acquiring certain businesses, products or technologies that it may from time to
time identify, and its related ability to finance such acquisitions. Assuming
that the Company does not pursue one or more additional acquisitions funded by
internal cash reserves, it anticipates that its existing capital, cash from
operations, and funds available under existing term loan and line of credit
agreements should be adequate to satisfy its capital requirements until the
fourth quarter of 1999. However, the Company cannot assure that it will not
require additional capital sooner than currently anticipated or that any such
additional funds will be adequate to fund its capital needs, which capital needs
depend upon numerous factors, including:
o the progress of its product development activities;
o the cost of increasing its sales and marketing activities; and
o the amount of revenues generated from operations.
None of the foregoing factors can be predicted with certainty. In addition, the
Company is unable to predict the precise amount of future capital that it will
require, particularly if it pursues one or more such acquisitions. Furthermore,
it can not assure that either additional financing will be available to it, or
if it is available, that such additional financing will be available on
acceptable terms. The Company's inability to obtain financing for such
acquisitions on acceptable terms may prevent it from completing advantageous
acquisitions and consequently could seriously harm its prospects and future
rates of growth. Its inability to obtain additional funding for continuing
operations or an acquisition would seriously harm its business, financial
condition and results of operations. Consequently, it could be required:
o to significantly reduce or suspend its operations;
o to seek a merger partner; or
o to sell additional securities on terms that are highly
dilutive to its existing investors.
DEPENDENCE ON TECHNOLOGICAL DEVELOPMENTS
The market for the distribution of digital audio and video
transmissions is characterized by rapidly changing technology. The Company's
success will depend, in part, on the technological quality of its products and
processes relative to those of its competitors and its ability to develop and
introduce new and enhanced products and services at competitive prices and in a
timely and cost-effective fashion. Its development efforts have been focused on:
o Satellite transmission technology;
o Video compression technology;
o TV station systems interfaces; and
o Reliability and throughput enhancements to the network.
The growth of its electronic video delivery services also depends on
its ability to obtain reliable and cost-effective satellite delivery capability.
Development efforts in satellite transmission technology are oriented to
development and deployment of software to lower transmission costs and increase
delivery reliability. Development efforts in video compression technology are
directed toward integration of emerging broadcast quality compression systems
within its existing network, thereby continuing to improve picture quality while
maintaining compliance with industry standards. TV station system interface
implementation includes various system control protocols and improvements of the
system throughput and reliability. The Company have an agreement with Hughes
Network Systems, Inc. ("Hughes") giving us access to Hughes' satellite capacity
for electronic delivery of digital audio and video transmissions by that media.
The Company has developed and incorporated the software designed to enable the
current DVPSs to receive digital satellite transmissions over the Hughes
satellite system. However, the Hughes
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satellite system may not have the capacity to meet its future delivery
commitments and broadcast quality requirements on a cost-effective basis, if at
all. See "Dependence on Certain Suppliers."
The introduction of new products can render existing products obsolete
or unmarketable. The Company may not be successful in identifying, developing,
contracting for the manufacture of, and marketing product enhancements or new
products that respond to technological change. In addition, the Company may
experience difficulties that could delay or prevent the successful development,
introduction and marketing of any new products or product enhancements, and
these products may not adequately meet the requirements of the marketplace and
achieve market acceptance. Delays in the introduction of new products and
services or enhancements to existing products and services may result in
customer dissatisfaction and delay or loss of revenue. The inability to develop
and introduce new products and services or enhancements of existing products and
services in a timely manner or with a significant degree of market acceptance
could seriously harm its business, financial condition and results of
operations.
DEPENDENCE ON RADIO ADVERTISING
Prior to its acquisitions of PDR and Mediatech, its revenues were
derived principally from a single line of business, the delivery of radio
advertising spots from advertising agencies, production studios and dub and ship
houses to radio stations in the United States. The Company expects the delivery
of such services to continue to account for a significant portion of its
revenues for some time. A decline in demand for, or average selling prices of,
its radio advertising delivery services for any of the following reasons, or
otherwise, would seriously harm its business, financial condition and results of
operations:
o competition from new advertising media;
o new product introductions or price competition from
competitors;
o a shift in purchases by customers away from its premium
services, such as DG Priority or Rush and DG Express or Same
Day; and
o a change in the technology used to deliver such services.
Additionally, the Company is dependent on its relationship with the radio
stations in which it has installed communications equipment. Should a
substantial number of these stations go out of business, experience a change in
ownership, or discontinue the use of its equipment in any way, it could
seriously harm its business, financial condition and results of operations.
COMPETITION
The Company currently competes in the market for the distribution of
audio advertising spots to radio stations and the distribution of video
advertising spots to television stations. The principal competitive factors
affecting these markets are ease of use, price, timeliness and accuracy of
delivery. The Company competes with a variety of dub and ship houses and
production studios that have traditionally distributed taped advertising spots
via physical delivery. Although such dub and ship houses and production studios
do not currently offer electronic delivery, they have long-standing ties to
local distributors that will be difficult for us to replace. Some of these dub
and ship houses and production studios have greater financial, distribution and
marketing resources and have achieved a higher level of brand recognition than
it has. In September 1998, the Company acquired substantially all of the assets
of DCI, a supplier of electronic distribution and communications services for
the radio broadcast industry in the United States and Canada. This acquisition
has resulted in:
o Expansion of its customer base;
o An increase in the number of radio stations included in its
network; and
o An improvement in its ability to provide a point to point
delivery service between the radio stations and groups.
o The Company believes that it offers the only nationwide
electronic delivery option for audio spot distribution. In the
market for the distribution of video content to television
stations, it encounters
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competition from numerous large and small dub and ship houses
and production studios, certain of which currently function as
marketing partners with DG Systems in the audio distribution
market.
To the extent that it is successful in entering new markets, such as the
delivery of other forms of content to radio and television stations, the Company
would expect to face competition from companies in related communications
markets and/or package delivery markets. Some of these companies in related
markets could offer products and services with functionality similar or superior
to that offered by its products and services. Telecommunications providers such
as AT&T, MCI Worldcom and Regional Bell Operating Companies could also enter the
market as competitors with materially lower electronic delivery transportation
costs. The Company could also face competition from entities with package
delivery expertise such as Federal Express, United Parcel Service, DHL and
Airborne if any such companies enter the electronic data delivery market. Radio
networks such as ABC or Westwood One could also become competitors by selling
and transmitting advertisements as a complement to their content programming.
Many of its current and potential competitors in the markets for audio
and video transmissions have substantially greater financial, technical,
marketing and other resources and larger installed customer bases than DG
Systems. The Company may not be able to compete successfully against current and
future competitors based on these and other factors. It expects that an
increasingly competitive environment will result in price reductions that could
result in lower profits and loss of market share, all of which would seriously
harm its business, financial condition and results of operations. Moreover, the
market for the distribution of audio and video transmissions has become
increasingly concentrated in recent years as a result of acquisitions, which are
likely to permit many of its competitors to devote significantly greater
resources to the development and marketing of new competitive products and
services. The Company expects that competition will increase substantially as a
result of these and other industry consolidations and alliances, as well as the
emergence of new competitors. Accordingly, it may not be able to compete
successfully with new or existing competitors, and the effects of such
competition could seriously harm its business, financial condition and results
of operations.
ABILITY TO MANAGE GROWTH
The Company have recently experienced a period of rapid growth that has
resulted in new and increased responsibilities for management personnel and that
has placed and continues to place a significant strain on its operating,
management and financial systems and resources. To accommodate this recent
growth and to compete effectively and manage future growth, if any, it must
continue to implement and improve its operational, financial and management
information systems, procedures and controls on a timely basis and to expand,
train, motivate and manage its work force. In particular, the Company believes
that to achieve these objectives it must complete the following:
o Automation of the customer order entry process;
o Integration of the delivery fulfillment process into the
customer billing system; and
o Combination of these systems with those of PDR, Mediatech and
DCI.
Its personnel, systems, procedures and controls may not be adequate to support
its existing and future operations. Any failure to implement and improve its
operational, financial and management systems or to expand, train, motivate or
manage its employees could seriously harm its business, financial condition and
results of operations.
OTHER RISKS ASSOCIATED WITH NASDAQ NATIONAL MARKET LISTING QUALIFICATION
The holders of the registered Common Stock of DG Systems currently
enjoy a substantial benefit in terms of liquidity by having such Common Stock
listed on the Nasdaq National Market trading system. This benefit would be lost
if the Company were to be delisted from the Nasdaq National Market. On November
25, 1998, the Company received notice from the Nasdaq Stock Market, Inc.
("Nasdaq") that, on the basis of its Quarterly Report on Form 10-Q for the
quarter ending September 30, 1998, its net tangible assets had fallen below the
level required for continued inclusion of its Common Stock on the Nasdaq
National Market trading system. On December 10, 1998, it submitted information
to Nasdaq that it had raised approximately $11 million and, therefore, believed
that it was once again in compliance with all of the requirements for continued
listing on the Nasdaq National Market.
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Nasdaq subsequently requested additional information regarding its August 1998
and December 1998 financing activities as well as its acquisition of
substantially all of the assets of DCI in order to ascertain its compliance with
applicable corporate governance rules. On December 17, 1998, the Company
submitted additional information to Nasdaq in response to this request. While
the Company believes it is currently in compliance with Nasdaq's continued
listing requirements and corporate governance rules, it cannot assure that
Nasdaq will make such a finding or that it will be able to continue to have its
registered Common Stock listed on the Nasdaq National Market or similar public
securities exchange.
YEAR 2000 READINESS DISCLOSURE
General:
Many currently installed computer systems and software products are
coded to accept only two digit entries in the date code field. Beginning in the
year 2000, these date codes fields will need to accept four digit entries to
distinguish 21st century dates from 20th century dates. As a result, in less
than nine months, many such currently installed computer systems and software
products used by many companies will need to be upgraded to enable such systems
and computer hardware and software products to avoid the potential effects
associated with the Year 2000 coding problem. To identify potential issues, the
Company utilized a third party consulting firm to assess the Year 2000 risk
regarding the level of dependence and the exposure of various internal and
external systems and related applications upon which the Company may be
dependent. With the completion of this third party assessment the Company has
developed a formal project plan.
The Company has completed a preliminary assessment of the components
and applications of its network and has determined that a number of these
components are Year 2000 compliant. The Company has a formal comprehensive
project plan in place and is currently taking the steps it believes are
necessary to make the remainder of the network and related applications, as well
as the other systems utilized by the Company, Year 2000 compliant. The Company's
project plan consists of five major phases: Awareness, Assessment, Detailed
Analysis and Preliminary Testing, System Conversion and Testing, and
Implementation. The above mentioned phases include education, a complete company
wide inventory assessment, testing and correction of all non-compliant systems.
Each piece of equipment or system will go through all five phases and will be
completed at different times throughout the year. The Company's goal is to reach
total Year 2000 compliance of all systems and equipment, technical and
non-technical, by November 1999. The Company's strategy also includes
development of contingency plans to address potential disruption of operations
arising from the Year 2000 problem. The Company is in the development stage of
contingency planning and, at this time, has not completed its contingency plan.
Awareness:
The Company believes that awareness of the Year 2000 problem is
critical to its business and employees. Therefore, the Company has chosen
several means of communicating the Year 2000 problem to each sector of its
business. These shall include, but are not limited to, executive staff meetings,
team meetings, E-mail notices, Website updates, and communication by US Mail to
customers and vendors.
Assessment:
The Company is assessing all systems including hardware, application
software and firmware. A complete company-wide inventory assessment is nearing
completion and is necessary to determine any potential Year 2000 issues. The
Company is currently reviewing each vendor's Year 2000 project plan and status.
Each vendor has or will receive a compliance letter and questionnaire to allow
the Company to gauge the vendor's compliance level. Non-Information Technology
equipment such as elevators, security systems, and electric power, have been
placed into the Service Provider category and each area is being monitored
closely to ensure that no disruption in services will occur. Mission critical
suppliers have been identified and contingency plans are being developed.
Detailed Analysis & Preliminary Testing:
The Company has completed preliminary testing and analysis on most
mission critical systems. Remote testing of offsite systems hardware is
scheduled to begin in April. All offsite systems are expected to be Year 2000
compliant by the third quarter of 1999. The Company's financial systems are
currently being upgraded. A detailed analysis and preliminary testing of each
remaining system is scheduled and/or is currently in progress.
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System Conversion & Testing:
The Company's network includes RPTs, CWs and DVPS strategically placed
across the country in broadcasting stations. The Company has direct network
control over its applications and has included detailed testing and correction
of all source code and associated data elements. Each unit will be remotely
tested and any necessary corrections or modifications will be made. Internally,
the Company utilizes many third party application software programs as well as
programs developed in-house. Upgrades and modifications will be tested and
implemented as needed.
Implementation:
The Company will implement new or upgraded software as needed to assure
its continuation of business with little or no risk of disruption from Year
2000. All systems compliance information will be documented and a contingency
plan for each system or service is scheduled to be in place by November of 1999.
Risks:
Although the Company has direct programming control over its network
applications, there can be no assurance that the Company's computer hardware and
software products will contain all necessary code changes in their date code
fields to avoid any or all damaging interruptions and other problems associated
with date entry limitations. The Company is also dependent upon other third
parties, in particular its telephone and satellite transmission suppliers, in
order to provide its electronic distribution services. The Company is in the
process of obtaining relevant information from these suppliers in order to
increase awareness of potential issues. If such vendors' systems are not Year
2000 compliant, it could have a material adverse affect on the Company's
operations. At this time, the Company has not fully quantified the potential
impact of third party vendor year 2000 issues.
The Company believes that the purchasing pattern of its current and
potential customers may be affected by the Year 2000 problem in a variety of
ways. For example, as the Year 2000 approaches, some of the Company's current
customers may develop concerns about the reliability of the Company's electronic
delivery services and, as a result, shift their delivery work to less technical
dub and ship operations. Likewise, some potential customers of the Company with
the same concern may elect not to utilize the Company's electronic delivery
services until after year 2000 and beyond. If any current customers of the
Company shift some or all of their delivery work to other delivery providers,
the Company's business, financial condition and results of operations will be
adversely affected, and if any potential customers elect to not utilize the
Company's delivery services for any period of time on the basis of Year 2000
concerns, the Company's business and financial prospects for growth could be
adversely affected. In addition to the foregoing, in the event that the Company
does experience interruptions and problems with its computer hardware and
software products due to Year 2000 limitations of such products, some or all of
the Company's current customers may shift some or all of their delivery work to
other delivery providers without year 2000 problems. Moreover, potential
customers of the Company may elect not to utilize the Company's delivery
services in the event of any such interruptions and problems. Any of the
foregoing could result in a loss of revenues which would have a material adverse
effect on the Company's business, financial condition and results of operations.
At this time, the Company is developing detailed contingency plans for the
possibility of significant disruption due to Year 2000 issues. Preliminary
discussions have been held but completion of the development of such a
contingency plan will be dependent upon the findings and resulting actions taken
based on the risk assessment studies discussed above.
Costs:
The Company currently does not anticipate that the direct resource
requirements or expenses of the Company related to resolving Year 2000 issues
will have a significant adverse effect on its operating results or financial
position. To date, the Company has incurred approximately $700,000 in Year 2000
readiness related expenses, and estimates that total Year 2000 related expenses
will be approximately $2 million.
The foregoing assessment is based on information currently available to
the Company. The Company can provide no assurance that applications and
equipment that the Company believes to be Year 2000 compliant will not
experience problems. Failure by the Company or third parties on which it relies
to resolve Year 2000 problems could have a material adverse effect on the
Company's results of operations.
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POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS; SEASONALITY
The Company's quarterly operating results have in the past and may in
the future vary significantly depending on factors such as:
o Volume of advertising in response to seasonal buying patterns;
o Timing of introductions of new products and services;
o Increased competition;
o Timing of its promotional efforts; and
o General economic factors.
For example, the Company has historically experienced lower sales in the first
quarter and higher sales in the fourth quarter due to increased customer
advertising volumes for the Christmas selling season. As a result, it believes
that period to period comparisons of its results of operations are not
necessarily meaningful and should not be relied upon as an indication of its
future performance. In any single period, its revenues and delivery costs are
subject to variation based on changes in the volume and mix of deliveries
performed during such period. In particular, its operating results have
historically been significantly influenced by the volume of deliveries ordered
by television stations during the "Sweeps" rating periods that currently take
place in February, May, August and November. The increased volume of these
deliveries during such periods and its relatively higher prices for "Sweeps"
advertisements have historically increased the total revenues and revenues per
delivery and tended to reduce relative delivery costs. Its expense levels are
based, in part, on its expectations of future sales levels. If sales levels are
below expectations, operating results are likely to be seriously harmed. In
addition, the Company has historically operated with little or no backlog. The
absence of backlog increases the difficulty of predicting sales and operating
results. Fluctuations in sales due to seasonality may become more pronounced as
its sales growth rate slows. Due to the unique nature of its products and
services,it believes that it will incur significant expenses for sales and
marketing, including advertising, to educate potential customers about such
products and services.
DEPENDENCE ON KEY PERSONNEL
The Company's success depends to a significant degree upon the
continuing contributions of, and on its ability to attract and retain, qualified
management, sales, operations, marketing and technical personnel. The Company
has employment agreements with certain of its key executives. In general, the
agreements provide for base salaries, bonuses, option grants based on certain
performance criteria, and terminations payments. It does not maintain key man
life insurance on the lives of any of its key personnel. The competition for
qualified personnel, particularly engineering staff, is intense, and it is
possible that it may not be able to continue to attract and retain qualified
management, sales and technical personnel for the development of its business.
If the Company is unable to attract, hire and retain qualified personnel in the
future, the success of its business could be impaired, and this could seriously
harm its business, operating results and financial condition.
DEPENDENCE ON CERTAIN SUPPLIERS
The Company relies on certain single or limited-source suppliers for
integral components used for the assembly of its audio and video units. Although
these suppliers are generally large, well-financed organizations, in the event
that a supplier were to experience financial or operational difficulties that
resulted in a reduction or interruption in component supply to DG Systems, it
would delay its deployment of audio and video units. This would have the effect
of depressing its business until it was able to establish sufficient component
supply through an alternative source. The Company believes that there are
currently alternative component manufacturers that could supply the components
required to produce its products, but it is not currently pursuing agreements or
understandings with such alternative sources. If a reduction or interruption of
supply were to occur, it could take a significant period of time for the Company
to qualify an alternative subcontractor, redesign its products as necessary and
contract for the manufacture of such products. The Company does not have
long-term supply contracts with its
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sole- or limited-source vendors, and it purchases its components on a purchase
order basis. The Company has experienced component shortages in the past, and
material component shortages or production or delivery delays may occur in the
future. The inability to continue to obtain sufficient quantities of components
in a timely manner, as required, or to develop alternative sources, as required,
could result in delays or reductions in product shipments or product redesigns,
which would seriously harm its business, financial condition and results of
operations.
Pursuant to its development efforts in the area of satellite
transmission technology, the Company has successfully completed live field
trials of software designed to enhance and enable the current RPTs to receive
digital satellite transmissions over the Hughes satellite system. The Company's
dependence on Hughes' satellite system entails a number of significant risks.
Its business, results of operations and financial condition would be seriously
harmed if Hughes were unable for any reason to continue to meet its delivery
commitments on a cost-effective basis or if any transmissions failed to satisfy
its quality requirements. In the event that the Company was unable to continue
to use Hughes' satellite capacity, it would have to identify, qualify and
transition deliveries to an acceptable alternative satellite transmission
vendor. Such an alternative satellite transmission vendor may not be available
in a position to satisfy its delivery requirements on a timely and
cost-effective basis, if at all. In the event that such an alternative satellite
transmission vendor were available, the identification, qualification and
transition process could take up to nine months or longer.
The Company obtains its local access telephone transmission services
through Teleport Communications Group. It obtains its long distance telephone
access through an exclusive contract with MCI Worldcom, which expires in 2001.
Any material interruption in the supply or a material adverse change in the
price of either local access or long distance carrier service could seriously
harm its business, results of operations and financial condition.
DEPENDENCE ON NEW PRODUCT INTRODUCTIONS
The Company's future growth depends on the successful and timely
introduction of new products and services in markets that do not currently exist
or are just emerging. Its goal is to introduce new services, such as media
archiving and the ability to quickly and reliably give an agency the ability to
preview and authorize electronic delivery of video advertising spots. The
Company may not be able to successfully complete development of such products
and services. Even if any such development is completed, it may not be able to
introduce these products and services and these products may not realize market
acceptance or meet the technical or other requirements of potential customers.
The failure to successfully develop and introduce new products and services
could seriously harm its business, financial condition and results of
operations.
DEPENDENCE ON PROPRIETARY TECHNOLOGY, PROTECTION OF TRADEMARKS, COPYRIGHTS, AND
OTHER PROPRIETARY INFORMATION; RISK OF THIRD PARTY CLAIMS OF INFRINGEMENT
The Company considers its trademarks, copyrights, advertising, and
promotion design and artwork to be of value and important to its business. It
relies on a combination of trade secret, copyright and trademark laws and
nondisclosure and other arrangements to protect its proprietary rights. We do
not have any patents or patent applications pending. We generally enter into
confidentiality or license agreements with its employees, distributors and
customers, and limit access to and distribution of its software, documentation
and other proprietary information. Despite its efforts to protect its
proprietary rights, unauthorized parties may attempt to copy or obtain and use
information that it regards as proprietary. The steps that it has taken to
protect its proprietary information may not prevent misappropriation of such
information and such protection may not preclude competitors from developing
confusingly similar brand names or promotional materials or developing products
and services similar to those of the Company. In addition, the laws of some
foreign countries do not protect its proprietary rights to the same extent as do
the laws of the United States. While the Company believes that its trademarks,
copyrights, advertising and promotion design and artwork do not infringe upon
the proprietary rights of third parties, it may still receive future
communications from third parties asserting that it is infringing, or may be
infringing, on the proprietary rights of third parties. Any such claims, with or
without merit, could be time-consuming, require the Company to enter into
royalty arrangements or result in costly litigation and diversion of management
personnel. If such claims are successful, the Company may not be able to obtain
any licenses necessary for the operation of its business or, if obtainable, such
licenses may not obtainable on commercially reasonable terms. In the event of a
successful claim
32
35
of infringement and its failure or inability to license the infringed or similar
proprietary information, its business, financial condition and results of
operations could be seriously harmed.
CONCENTRATION OF STOCK OWNERSHIP; ANTITAKEOVER PROVISIONS
The present executive officers and directors of DG Systems and its
respective affiliates own approximately 44% of its Common Stock. As a result,
these shareholders will be able to control or significantly influence all
matters requiring shareholder approval, including the election of directors and
the approval of significant corporate transactions. Such concentration of
ownership may have the effect of delaying or preventing a change in control of
DG Systems. Furthermore, certain provisions of its Amended and Restated Articles
of Incorporation and Bylaws, and of California law, could have the effect of
delaying, deferring or preventing a change in control of DG Systems.
PREFERENTIAL RIGHTS OF PREFERRED STOCK
DG Systems presently has 15,000,000 shares of Preferred Stock
authorized. On August 12, 1998, the holders of 4,950,495 shares of Series A
Convertible Preferred Stock, constituting all of the outstanding shares of the
Series A Convertible Preferred Stock, elected to convert such shares into shares
of its Common Stock. Accordingly, pursuant to its Articles of Incorporation, the
Board of Directors has the authority to issue up to 10,049,505 additional shares
of Preferred Stock and may divide such 10,049,505 remaining authorized shares of
Preferred Stock into any number of series, to fix the number of shares of any
such series and to determine the rights, preferences, privileges and
restrictions granted to or imposed upon, any such series.
REGISTRATION RIGHTS
In connection with the August and December 1998 private placements of shares of
its Common Stock, as further described in "Market for Registrant's Common Stock
and Related Shareholder Matters," the Company agreed to prepare and file a
Registration Statement on Form S-3 (the "Registration Statement"), with the
Security and Exchange Commission for the purposes of registering the resale of
such shares and to list such shares on the Nasdaq National Market. Certain other
holders of its Common Stock, including former holders of its Series A
Convertible Preferred Stock, previously have been granted demand and piggy-back
registration rights, such that such holders were entitled to include their
shares in this registration process and any such subsequent registration
process. The Registration Statement, effective as of February 12, 1999,
registers 15,214,220 shares of its Common Stock. The Company has agreed to use
commercially reasonable efforts to keep the Registration Statement effective for
the lesser of until the date as to which all such shares of Common Stock may be
sold by the holders thereof without registration in a single transaction
pursuant to Rule 144(k) under the Act or until all such shares have been sold.
In addition, in connection with the December 9, 1998 issuance of warrants to
purchase its Common Stock, as further described in "Market for Registrant's
Common Stock and Related Shareholder Matters," the Company granted the holders
of such warrants demand registration rights with respect to the shares of Common
Stock issuable upon exercise of such warrants.
Following the successful completion of such registration on Form
S-3, the additional 15,214,220,shares of DG Systems' Common Stock registered
thereunder will be freely tradable in the public market, subject to volume
limitations applicable to affiliates of DG Systems. Sales of a substantial
number of additional shares in the public market could seriously harm the market
price of DG System's Common Stock and could impair its future ability to raise
capital through the sale of its equity securities.
EXPANSION INTO INTERNATIONAL MARKETS
Although the Company's long-term plans include expansion of its
operations to Europe and Asia, it does not at present have network operating
center personnel experienced in operating in these locations. Telecommunications
standards in foreign countries differ from those in the United States and may
require us to incur substantial costs and expend significant managerial
resources to obtain any necessary regulatory approvals and to comply with
differing equipment interface and installation standards promulgated by
regulatory authorities of those countries. Changes in
33
36
government policies, regulations and telecommunications systems in foreign
countries could require its products and services to be redesigned, causing
product and service delivery delays that could seriously harm its operating
results. The Company's ability to successfully enter these new markets will
depend, in part, on its ability to attract personnel with experience in these
locations and to attract partners with the necessary local business
relationships. However, the Company cannot assure that its products and services
will achieve market acceptance in foreign countries. Its inability to
successfully establish and expand its international operations may also limit
its ability to obtain significant international revenues and could seriously
harm its business, operating results and financial condition. Furthermore,
international business is subject to a number of country-specific risks and
circumstances, including
o different tax laws;
o difficulties in expatriating profits;
o currency exchange rate fluctuations; and
o the complexities of administering business abroad.
Moreover, to the extent the Company increases its international sales, its
business, operating results and financial condition could be seriously harmed by
these risks and circumstances, as well as by increases in duties, price controls
or other restrictions on foreign currencies, and trade barriers imposed by
foreign governments, among other factors.
POSSIBLE VOLATILITY OF SHARE PRICE
The trading prices of its Common Stock may be subject to wide
fluctuations in response to a number of factors, including:
o variations in operating results;
o changes in earnings estimates by securities analysts;
o announcements of extraordinary events such as litigation or
acquisitions;
o announcements of technological innovations or new products or
services by DG Systems or its competitors; and
o general economic, political and market conditions.
In addition, stock markets have experienced extreme price and volume trading
volatility in recent years. This volatility has had a substantial effect on the
market prices of the securities of many high technology companies for reasons
frequently unrelated to the operating performance of specific companies. These
broad market fluctuations may adversely affect the market price of its Common
Stock.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item is set forth in the Company's
Consolidated Financial Statements and the Notes thereto beginning at Page F-1 of
this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
34
37
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item with respect to the Company's
directors is incorporated by reference to the information contained in the
section captioned "Proposal One -- Election of Directors" in the definitive
proxy statement to be filed with the Securities and Exchange Commission by the
Company for its 1999 Annual Meeting of Shareholders (the "Proxy Statement"). The
Proxy Statement is anticipated to be filed within 120 days after the end of the
Company's fiscal year ended December 31, 1998. For information with respect to
executive officers of the Company, see Item 4A of this Annual Report on Form
10-K.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from
the section captioned "Executive Compensation" contained in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from
the section captioned "Security Ownership of Certain Beneficial Owners and
Management" contained in the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference to
the information contained in the sections captioned "Compensation Committee
Interlocks and Insider Participation" and "Certain Transactions with Management"
contained in the Proxy Statement.
35
38
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) 1. FINANCIAL STATEMENTS
The following financial statements are filed as part of this Report:
PAGE
----
Report of Arthur Andersen LLP, Independent Public Accountants.......... F-2
Consolidated Balance Sheets............................................ F-3
Consolidated Statements of Operations.................................. F-4
Consolidated Statements of Stockholders' Equity........................ F-5
Consolidated Statements of Cash Flows.................................. F-6
Notes to Consolidated Financial Statements............................. F-7
(a) 2. FINANCIAL STATEMENT SCHEDULES
II - Valuation and Qualifying Accounts ................................ S-1
EXHIBITS AND REPORTS ON FORM 8-K
(a) 3. EXHIBITS
EXHIBIT NUMBER EXHIBIT TITLE
- -------------- -------------
3.1.1 (d) Restated Articles of Incorporation of registrant.
3.1.2 (h) Certificate of Determination of Rights of Series A Convertible
Preferred Stock of Digital Generation Systems, Inc., filed
by the Secretary of State of the State of California on
July 16, 1997.
3.2 (b) Bylaws of registrant, as amended to date.
4.1 (b) Form of Lock-Up Agreement.
4.2 (b) Form of Common Stock Certificate.
10.1 (b) 1992 Stock Option Plan (as amended) and forms of Incentive
Stock Option Agreement and Non-statutory Stock Option
Agreement.
10.2 (b) Form of Directors' and Officers' Indemnification Agreement.
10.3 (b) 1995 Director Option Plan and form of Incentive Stock Option
Agreement thereto.
10.4 (b) Form of Restricted Stock Agreement.
10.5.1 (c) Content Delivery Agreement between the Company and Hughes Network
Systems, Inc., dated November 28, 1995.
10.5.2 (c) Equipment Reseller Agreement between the Company and Hughes Network
Systems, Inc., dated November 28, 1995.
10.6 (b) Amendment to Warrant Agreement between the Company and Comdisco,
Inc., dated January 31, 1996.
10.7(j) Special Customer Agreement between the Company and MCI
Telecommunications Corporation, dated May 5, 1997.
10.8 (b) Master Lease Agreement between the Company and Comdisco, Inc.,
dated October 20, 1994, and Exhibits thereto.
36
39
EXHIBIT NUMBER EXHIBIT TITLE
- -------------- -------------
10.9 (b) Loan and Security Agreement between the Company and Comdisco, Inc.,
dated October 20, 1994, and Exhibits thereto.
10.10 (b) Master Equipment Lease between the Company and Phoenix Leasing,
Inc., dated January 7, 1993.
10.15 (c) Audio Server Network Prototype Vendor Agreement and Satellite
Vendor Agreement between the Company and ABC Radio Networks, dated
December 15, 1995.
10.17 (b) Promissory Note between the Company and Henry W. Donaldson, dated
March 18, 1994, December 5, 1994, December 5, 1994, and March 14,
1995.
10.18 (b) Warrant Agreement to purchase Series B Preferred Stock
between the Company and Comdisco, Inc., dated as of October
20, 1994.
10.19 (b) Warrant Agreement to purchase Series C Preferred Stock between the
Company and Comdisco, Inc., dated as of June 13, 1995.
10.20 (b) Warrant Agreement to purchase Series D Preferred Stock
between the Company and Comdisco, Inc., dated as of January
11, 1996.
10.22 (d) Agreement of Sublease for 9,434 rentable square feet at 855 Battery
Street, San Francisco, California between the Company and T.Y. Lin
International dated September 8, 1995 and exhibits thereto.
10.23 (d) Agreement of Sublease for 5,613 rentable square feet at 855 Battery
Street, San Francisco, California between the Company and
Law/Crandall, Inc. dated September 29, 1995 and exhibits thereto.
10.24 (e) Digital Generation Systems, Inc. Supplemental Stock Option Plan.
10.25 (e) Stock Purchase Agreement by and among Digital Generation Systems,
Inc. and PDR Productions, Inc. and Pat DeRosa dated as of October 15, 1996
and exhibits thereto.
10.26 (f) Amendment to Stock Purchase Agreement dated November 8, 1996, among
Digital Generation Systems, Inc., and Pat DeRosa.
10.27 (h) Loan Agreement dated as of January 28, 1997 between Digital
Generation Systems, Inc. as Borrower, and Venture Lending and
Leasing, Inc. as Lender and exhibits thereto.
10.28 (i) Stock Purchase Agreement, dated as of July 18, 1997, by and between
Digital Generation Systems, Inc., a California corporation,
IndeNet, Inc., a Delaware Corporation, and exhibits thereto.
10.29 (i) Preferred Stock Purchase Agreement, dated as of July 14, 1997, by
and among Digital Generation Systems, Inc. and the parties listed
on the Schedule of Purchasers attached, as Exhibit A thereto.
10.30 (i) Amendment to Preferred Stock Purchase Agreement, dated as of July
23, 1997, by and among Digital Generation Systems, Inc. and the
purchasers listed on the Exhibit A thereto.
10.31 (k) Loan Agreement dated as of December 1, 1997 between Digital
Generation Systems, Inc. as Borrower, and Venture Lending and
Leasing, Inc. as Lender and exhibits thereto.
10.32 (a) First Amendment to Loan Agreement dated as of January 28, 1997
between Digital Generation Systems, Inc. as Borrower, and Venture
Lending and Leasing, Inc. as Lender and exhibits thereto.
10.33 (l) Common Stock Subscription Agreement for private placement
of Company's Common Stock at $2.80 per share.
10.34 (m) Sale and Purchase Agreement, dated September 10, 1998, by and
between Grant Thornton Limited, in its capacity as Receiver-Manager
of Digital Courier International Corporation and Digital Courier
International, Inc. and Digital Generation Systems, Inc. and
exhibits thereto.
10.35 (n) Series A Preferred Stock Conversion Agreement dated as of August
12, 1998.
10.36 (p) Amendment and Restatement No. 5 of the Registration Rights
Agreement, dated July 14, 1997, by and among the Registrant and
certain of its securityholders.
37
40
EXHIBIT NUMBER EXHIBIT TITLE
- -------------- -------------
10.37 (p) Amended and Restated Registration Rights Agreement, dated December
9, 1998, by and among the Registrant and certain of its
securityholders
10.38 (p) Registration Rights Agreement, dated December 9, 1998, by and among
the Registrant and certain of its securityholders.
10.39(a) Common Stock and Warrant Purchase Agreement dated December 9, 1998
by and among the registrant and investors listed in Schedule A
thereto.
10.40(a) Common Stock Subscription Agreement dated December 9, 1998 by and
among the Registrant and Scott Ginsburg.
10.41(a) Warrant Purchase Agreement dated December 9, 1998 by and among the
Registrant and Scott Ginsburg.
10.42(a) Warrant No. 1 to Purchase Common Stock dated December 9, 1998 by
and among Registrant and Scott K. Ginsburg.
10.43(a) Warrant No. 2 to Purchase Common Stock dated December 9, 1998 by
and among Registrant and Scott K. Ginsburg
11.1 (a) Statements of computation of weighted average common shares.
21.1 (a) Subsidiaries of the Registrant.
23.1 (a) Consent of Independent Public Accountants.
27 (a) Financial Data Schedule.
- - - - - - - - - - - -
(a) Filed herewith.
(b) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Registration Statement on Form S-1 (Registration No.
33-80203).
(c) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Registration Statement on Form S-1 (Registration No.
33-80203). The registrant has received confidential treatment with respect
to certain portions of this exhibit. Such portions have been omitted from
this exhibit and have been filed separately with the Securities and
Exchange Commission.
(d) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Quarterly Report on Form 10-Q filed May 3, 1996, as amended.
(e) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Quarterly report on Form 10-Q filed November 13, 1996.
(f) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Current Report on Form 8-K/A filed January 21, 1997.
(g) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Annual Report on Form 10-K filed March 18, 1997.
(h) Incorporated by reference to the exhibit bearing the same number filed with
registrant's quarterly report on Form 10-Q filed May 15, 1997.
(i) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Form 8-K filed August 1, 1997.
(j) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Quarterly report on Form 10-Q filed August 14, 1997.
Confidential treatment has been requested with respect to certain portions
of this exhibit pursuant to a request for confidential treatment filed with
the Securities and Exchange Commission. Omitted portions have been filed
separately with the Commission.
(k) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Annual Report on Form 10-K filed March 31, 1998.
(l) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Quarterly report on Form 10-Q filed May 15, 1998.
(m) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Quarterly report on Form 10-Q filed August 14, 1998.
(n) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Current Report on Form 8-K filed October 13, 1998.
(o) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Quarterly report on Form 10-Q filed November 16, 1998.
(p) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Registration Report on Form S-3 filed on December 31, 1998.
38
41
(b) REPORTS ON FORM 8-K
(1) Current Report on Form 8-K filed on December 3, 1998 regarding the
Registrant's Year 2000 Readiness.
(2) Current Report on Form 8-K filed on December 28, 1998 regarding the
appointment of Scott K. Ginsburg as the Company's Chairman of the Board and
Chief Executive Officer effective December 11, 1998.
(c) EXHIBITS
See items 14 (a) (3) above.
(d) FINANCIAL STATEMENT SCHEDULES
See Item 14(a) (2) above.
39
42
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
DIGITAL GENERATION SYSTEMS, INC.
Dated: March 29, 1999 By: /S/ SCOTT K. GINSBURG
--------------------------------------
Scott K. Ginsburg
Chairman of the Board and Chief
Executive Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below hereby constitutes and appoints Scott K. Ginsburg as his
attorney-in-fact, with full power of substitution for him in any and all
capacities, to sign any and all amendments to this report on Form 10-K, and to
file the same, with exhibits thereto, and other documents in connection
therewith, with the Securities and Exchange Commission.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/S/ / SCOTT K. GINSBURG Chairman of the Board, Chief Executive Officer March 29, 1999
- ----------------------------
Scott K. Ginsburg and Director (Principal Executive Officer)
/s/ HENRY W. DONALDSON President, Chief Operating March 29, 1999
- ----------------------------
Henry W. Donaldson Officer and Director
/s/ PAUL W. EMERY, II Chief Financial Officer
- ----------------------------
Paul W. Emery, II (Principal Financial and Accounting Officer) March 29, 1999
/s/ KEVIN R. COMPTON Director March 29, 1999
- ----------------------------
Kevin R. Compton
/s/ JEFFREY M. DRAZAN Director March 29, 1999
- ----------------------------
Jeffrey M. Drazan
/s/ RICHARD H. HARRIS Director March 29, 1999
- ----------------------------
Richard H. Harris
/s/ LAWRENCE D. LENIHAN, JR. Director March 29, 1999
- ----------------------------
Lawrence D. Lenihan, Jr.
/s/ LEONARD S. MATTHEWS Director March 29, 1999
- ----------------------------
Leonard S. Matthews
40
43
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Digital Generation Systems, Inc.:
We have audited the accompanying consolidated balance sheets of Digital
Generation Systems, Inc. (a California Corporation) and subsidiaries as of
December 31, 1998 and 1997, and the related consolidated statements of
operations, shareholders' equity and cash flows for each of the three years in
the period ended December 31, 1998. These financial statements and the schedule
referred to below are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Digital Generation Systems,
Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed under Item 14(a)2 is
presented for purposes of complying with the Securities and Exchange
Commission's rules and is not a required part of the basic financial statements.
This schedule has been subjected to the auditing procedures applied in our
audits of the basic financial statements and, in our opinion, fairly states in
all material respects the financial data required to be set forth therein in
relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN, LLP
San Francisco, California
January 26, 1999
F-2
44
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
DECEMBER 31, DECEMBER 31,
1998 1997
------------ ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 13,025 $ 7,833
Short-term investments -- 987
Accounts receivable, less allowance for doubtful
accounts of $1,895 in 1998 and $585 in 1997 9,995 8,053
Prepaid expenses and other 933 649
--------- ---------
Total current assets 23,953 17,522
--------- ---------
PROPERTY AND EQUIPMENT, at cost:
Network equipment 33,211 30,405
Office furniture and equipment 3,730 2,963
Leasehold improvements 542 506
--------- ---------
37,483 33,874
Less - Accumulated depreciation and amortization (25,738) (16,308)
--------- ---------
Property and equipment, net 11,745 17,566
--------- ---------
GOODWILL AND OTHER ASSETS, net 14,094 25,609
--------- ---------
$ 49,792 $ 60,697
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 3,035 $ 4,506
Accrued liabilities 4,081 3,501
Line of credit 1,433 2,834
Current portion of long-term debt 8,226 7,560
--------- ---------
Total current liabilities 16,775 18,401
--------- ---------
LONG-TERM DEBT, net of current portion 9,307 11,847
--------- ---------
COMMITMENTS AND CONTINGENCIES (Note 5)
SHAREHOLDERS' EQUITY:
Convertible preferred stock, no par value - Authorized - - 15,000,000
shares at December 31, 1998;
5,000,000 shares at December 31, 1997
Outstanding - - none at December 31, 1998 and 4,950,495 at
December 31, 1997 -- 31,561
Common Stock, no par value -
Authorized - - 40,000,000 shares at December 31, 1998; 30,000,000
shares at December 31, 1997
Outstanding - - 26,239,520 shares at December 31, 1998
and 12,122,679 shares at December 31, 1997 114,131 57,123
Receivable from issuance of Common Stock (369) (175)
Accumulated other comprehensive income 9 --
Accumulated deficit (90,061) (58,060)
--------- ---------
Total shareholders' equity 23,710 30,449
--------- ---------
$ 49,792 $ 60,697
========= =========
The accompanying notes are an integral part of
these consolidated financial statements.
F-3
45
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEARS ENDED DECEMBER 31,
------------------------------------------------------
1998 1997 1996
-------- -------- --------
REVENUES $ 41,270 $ 29,175 $ 10,523
-------- -------- --------
COSTS AND EXPENSES:
Delivery and material costs 14,630 11,334 3,084
Customer operations 14,780 11,388 4,164
Sales and marketing 4,970 4,417 3,998
Research and development 2,780 2,473 2,092
General and administrative 4,314 3,169 1,677
Write down of subsidiary (Note 3) 17,006 -- --
Depreciation and amortization 10,266 9,306 4,331
-------- -------- --------
Total expenses 68,746 42,087 19,346
-------- -------- --------
LOSS FROM OPERATIONS (27,476) (12,912) (8,823)
OTHER INCOME (EXPENSE):
Interest income 243 744 1,422
Interest expense (3,014) (2,607) (1,726)
Gain from foreign exchange 10 -- --
-------- -------- --------
NET LOSS $(30,237) $(14,775) $ (9,127)
======== ======== ========
BASIC AND DILUTED NET LOSS PER COMMON SHARE (Note 11)
$ (1.97) $ (2.52) $ (0.87)
======== ======== ========
WEIGHTED AVERAGE COMMON SHARES 16,272 11,893 10,488
======== ======== ========
The accompanying notes are an integral part of
these consolidated financial statements.
F-4
46
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
CONVERTIBLE
PREFERRED STOCK COMMON STOCK
SHARES AMOUNT SHARES AMOUNT
------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1995 7,273,759 $ 25,321 1,112,204 $ 224
Conversion of preferred stock
to Common Stock (7,273,759) (25,321) 7,273,759 25,321
Issuance of Common Stock in
connection with initial public
offering, net of issuance
costs of $1,200 -- -- 3,000,000 29,490
Net exercise of stock warrants
for surrender of 5,839
additional warrants -- -- 29,161 --
Exercise of stock options at
$.20 to $7.00 per share -- -- 238,501 103
Net loss -- -- -- --
------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1996 -- -- 11,653,625 55,138
Issuance of Series A preferred
stock, net of issuance costs
of $1,100 4,950,495 16,400 -- --
Preferred stock deemed dividend (15,161) --
Issuance of Common Stock in
connection with acquisition
of Mediatech
-- -- 324,355 1,906
Exercise of stock options at
$.20 to $5.00 per share
-- 144,699 79
Net loss -- -- -- --
------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1997 4,950,495 31,561 12,122,679 57,123
August 98 issuance of common
stock in private placement,
net of issuance costs of $150 -- -- 4,589,287 12,700
Conversion of Series A preferred
stock to Common Stock, net
of issuance costs of $486 (4,950,495) (31,561) 4,950,495 31,075
Preferred stock deemed dividend
resulting from conversion of
Series A preferred stock -- -- 495,035 1,764
December 98 issuance of common
stock in private placement,
net of issuance costs of $220 -- -- 3,843,212 10,780
Warrants issued in relation to
December 98 common
stock private placement -- -- -- 12
Issuance of restricted stock
with promissory note -- -- 50,000 194
Exercise of stock options at
$.20 to $4.56 per share -- -- 174,701 371
0 80
Stock issued for services rendered
Purchase of shares through ESPP
at $2.26 per share 14,111 32
Foreign currency translation
adjustment -- -- -- --
Net loss -- -- -- --
------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1998 -- $ -- 26,239,520 $ 114,131
------------ ------------ ------------ ------------
RECEIVABLE ACCUMULATED
FROM OTHER TOTAL
ISSUANCE OF COMPREHENSIVE ACCUMULATED SHAREHOLDERS' COMPREHENSIVE
COMMON STOCK INCOME DEFICIT EQUITY INCOME/(LOSS)
------------ ------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1995 $ (175) $ -- $ (18,997) $ 6,373 $ --
Conversion of preferred stock
to Common Stock -- -- -- -- --
Issuance of Common Stock in
connection with initial public
offering, net of issuance
costs of $1,200 -- -- -- 29,490 --
Net exercise of stock warrants
for surrender of 5,839
additional warrants -- -- -- -- --
Exercise of stock options at
$.20 to $7.00 per share -- -- -- 103 --
Net loss -- -- (9,127) (9,127) $ (9,127)
------------ ------------ ------------ ------------ ------------
(175) (28,124) 26,839
BALANCE AT DECEMBER 31, 1996
-- --
Issuance of Series A preferred
stock, net of issuance costs
of $1,100 -- -- -- 16,400 --
Preferred stock deemed dividend (15,161)
Issuance of Common Stock in
connection with acquisition
of Mediatech
-- -- -- 1,906 --
Exercise of stock options at
$.20 to $5.00 per share
-- -- -- 79 --
Net loss -- -- (14,775) (14,775) $ (14,775)
------------ ------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1997 (175) -- (58,060) 30,449
August 98 issuance of common
stock in private placement,
net of issuance costs of $150 -- -- -- 12,700 --
Conversion of Series A preferred
stock to Common Stock, net
of issuance costs of $486 -- -- -- (486) --
Preferred stock deemed dividend
resulting from conversion of
Series A preferred stock -- -- (1,764) -- --
December 98 issuance of common
stock in private placement,
net of issuance costs of $220 -- -- -- 10,780 --
Warrants issued in relation to
December 98 common
stock private placement -- -- -- 12 --
Issuance of restricted stock
with promissory note (194) -- -- -- --
Exercise of stock options at
$.20 to $4.56 per share -- -- -- 451 --
Stock issued for services rendered
Purchase of shares through ESPP
at $2.26 per share
Foreign currency translation
adjustment -- 9 -- 9 9
Net loss -- -- (30,237) (30,237) $ (30,237)
------------ ------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1998 $ (369) $ 9 $ (90,061) $ 23,710 $ (30,228)
------------ ------------ ------------ ------------ ------------
The accompanying notes are an integral part of
these consolidated financial statements.
F-5
47
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
------------------------------------------
1998 1997 1996
-------- -------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(30,237) $(14,775) $ (9,127)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 9,103 8,519 4,260
Amortization of goodwill and intangibles 1,163 787 71
Foreign currency translation adjustment 9 -- --
Write-down of subsidiary (Note 3) 17,006 -- --
Stock issued for services rendered 80 -- --
Provision for doubtful accounts 1,310 246 97
Changes in operating assets and liabilities --
Accounts receivable (2,121) (122) (779)
Prepaid expenses and other assets (213) (212) (27)
Accounts payable and accrued liabilities (891) (751) 1,241
-------- -------- --------
Net cash used in operating activities (4,791) (6,308) (4,264)
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments (2,013) (8,810) (33,138)
Maturities of short-term investments 3,000 18,738 22,223
Acquisition of PDR, net of cash acquired -- -- (6,394)
Acquisition of Mediatech, net of cash acquired -- (13,921) --
Acquisition of DCI (9,131) -- --
Acquisition of property and equipment (2,162) (5,131) (2,417)
-------- -------- --------
Net cash used in investing activities (10,306) (9,124) (19,726)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock, net 23,975 79 29,593
Proceeds from issuance of convertible preferred stock -- 16,400 --
Proceeds from line of credit 13,365 7,686 --
Costs of converting preferred stock to common stock (486) -- --
Payments on line of credit (14,767) (8,027) --
Proceeds from short-term loans used to finance Mediatech acquisition -- 6,000 --
Repayment of short-term loans used to finance Mediatech acquisition -- (6,000) --
Proceeds from issuance of long-term debt 5,233 5,419 --
Payments on long-term debt (7,106) (7,974) (2,126)
-------- -------- --------
Net cash provided by financing activities 20,214 13,583 27,467
-------- -------- --------
EFFECT OF EXCHANGE RATE CHANGES (75) -- --
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 5,192 (1,849) 3,477
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 7,833 9,682 6,205
-------- -------- --------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 13,025 $ 7,833 $ 9,682
======== ======== ========
SUPPLEMENTAL CASH FLOW INFORMATION:
Interest paid $ 2,777 $ 2,502 $ 1,716
======== ======== ========
The accompanying notes are an integral
part of these consolidated financial statements.
F-6
48
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY:
Digital Generation Systems, Inc. (the "Company") was incorporated in
1991. The Company operates a nationwide multimedia network designed to provide
media distribution and related services to the broadcast industry by linking
content providers to radio and television stations. The Company is primarily a
provider of electronic and physical distribution of audio and video spot
advertising to radio and television stations. The Company primarily generates
its revenues from advertising agencies and production studios.
The Company is subject to certain risks that include, but are not
limited to: the continued development of technology to enhance the delivery and
variety of the Company's services in the most cost-effective manner, including
the successful integration of the operations of its recently acquired
subsidiaries; the ability to compete successfully against current and future
competitors; and dependence on key personnel and the need for additional
financing to fund operations and its capital expenditure requirements. The
Company obtains certain components used in the assembly of the units which are
placed at radio and television stations and production studios from a few single
or limited source suppliers and obtains its primary long distance telephone
access through an exclusive contract with a telephone service provider which
expires in 2001. Any material interruption in these services could have a
material adverse effect on the Company's business. Although the Company believes
that alternate vendors can be obtained, the transition to alternative vendors
could have a material adverse impact on the Company's costs and shipping
schedules.
2. ACQUISITIONS:
PDR PRODUCTIONS
On November 8, 1996, the Company completed the acquisition of 100% of
the capital stock of PDR Productions, Inc. ("PDR"), a media duplication and
distribution company located in New York City, for $6.5 million in cash and a
$2.5 million promissory note with interest payable at 8%. The note and accrued
interest were paid in November 1997. The acquisition was accounted for as a
purchase. The fair value of assets and liabilities acquired was approximately
$1.5 million. The excess of purchase price and acquisition costs over the fair
value of assets acquired of approximately $7.9 million, has been included in
Goodwill and Other Assets in the accompanying consolidated balance sheets and is
being amortized over a twenty year period. Related amortization expense of
$443,000, $427,000 and $71,000 is included in the consolidated statements of
operations for the years ended December 31, 1998, 1997, and 1996 respectively.
MEDIATECH
On July 18, 1997, the Company acquired 100% of the capital stock of
Starcom Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet,
Inc. ("IndeNet"), for final consideration totaling approximately $25.2 million
("Mediatech Acquisition"). The consideration consisted of approximately $14.0
million in cash, 324,355 shares of the Company's Common Stock and $9.2 million
of debt. Mediatech is a media duplication and distribution company whose
principal offices are located in Chicago, Illinois.
The Mediatech acquisition was accounted for as a purchase. The excess
of purchase price and acquisition costs over the fair value of net assets
acquired of approximately $17.8 million, had been included in Goodwill and Other
Assets in the accompanying consolidated balance sheet at December 31, 1997.
Amortization expense of approximately $648,000 and $360,000 is included in the
consolidated statement of operations for the twelve months ended December 31,
1998 and 1997, respectively. In September, 1998, the Company wrote down the
outstanding goodwill resulting from the Mediatech acquisition and a portion
of the fixed assets of Mediatech, as it was determined that their carrying
values were not recoverable (Note 3). The operating results of Mediatech have
been included in the consolidated results of the Company from the date of the
closing of the transaction, July 18, 1997.
F-7
49
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DCI
On September 25, 1998, the Company acquired substantially all of the
property and assets, including all accounts receivable, inventories, contracts,
equipment, real property leases and other related assets of Digital Courier
International, Inc. ("DCI"). DCI is in the business of supplying electronic
distribution and communications services for the radio broadcast industry in the
United States and Canada.
The Company paid $13.5 million in Canadian dollars (approximately US
$9.06 million) for DCI. The DCI acquisition was accounted for as a purchase. The
excess of purchase price and acquisition costs over the fair value of assets
acquired of approximately $6.2 million has been included in Goodwill and Other
Assets in the accompanying consolidated balance sheet as of December 31, 1998,
and is being amortized over a twenty year period. The operating results of DCI
have been included in the consolidated results and balances of the Company from
the date of the closing of the transaction, September 25, 1998. Amortization
expense of $72,000 is included in the consolidated statements of operations for
the years ended December 31, 1998.
PRO FORMA RESULTS
The following table reflects unaudited pro forma combined results of
operations of the Company on the basis that the acquisitions of both Mediatech
and DCI had taken place at the beginning of the fiscal years presented:
YEARS ENDED
DECEMBER 31,
-------------------------
1998 1997
-------- --------
Revenues .............................................. $ 44,506 $ 43,625
Net Loss .............................................. (35,277) (26,051)
Basic and Diluted Net Loss Per Common Share (Note 11) . $ (3.10) $ (3.54)
The unaudited pro forma combined results of operations are not
necessarily indicative of the actual results that would have occurred had the
acquisitions of Mediatech and DCI been consummated at the beginning of 1997 or
1998, or of future operations of the combined companies under the ownership and
management of the Company.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
CONSOLIDATION
The consolidated financial statements include the accounts of the
Company and its subsidiaries, PDR, Mediatech and DCI after elimination of
intercompany accounts and transactions.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
FOREIGN CURRENCIES
Assets and liabilities recorded in foreign currencies are translated at
the exchange rate on the balance sheet date. Translation adjustments resulting
from this process are charged or credited to equity. Revenue, costs, and
expenses are translated at average rates of exchange prevailing during the year.
Gains and losses on foreign currency transactions are included in Other
expenses.
F-8
50
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
RESEARCH AND DEVELOPMENT
Research and development costs are expensed as incurred. Statement of
Financial Accounting Standards ("SFAS") No. 86, "Accounting for the Costs of
Computer Software to Be Sold, Leased, or Otherwise Marketed", does not
materially affect the Company.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company has adopted SFAS No. 121, "Accounting for the Impairment of
Long-lived Assets and for Long-lived Assets to be Disposed of" ("Statement
121"). Statement 121 requires that long-lived assets be reviewed for impairment
and written down to fair value whenever events or changes in circumstances
indicate that the carrying value of assets may not be recoverable. In September
1998, the Company wrote off all of the remaining goodwill of its Mediatech
subsidiary, $16.7 million, and wrote down Mediatech's fixed assets by an
additional $340,000 due to management's evaluation of the appropriate carrying
value of Mediatech's assets. Because of a change in Mediatech's business, it was
determined that the value of the investment had permanently declined. The fair
value of the Mediatech asset was determined by discounting related expected
future cash flows.
CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
Cash and cash equivalents consist of liquid investments with original
maturities of three months or less. Short-term investments are marketable
securities with original maturities greater than three months and less than one
year. The Company has classified all marketable debt securities as
held-to-maturity and has accounted for these investments using the amortized
cost method. As of December 31, 1998 and December 31, 1997, cash and cash
equivalents and short-term investments consist principally of U.S. Treasury
bills and various money market accounts; as a result, the amortized purchase
cost approximates the fair market value.
PROPERTY AND EQUIPMENT
Network equipment includes the network operating center, Record Send
Terminals, Receive Playback Terminals, Video Record Transmission Systems,
Digital Video Playback Systems and the related terminal and system components as
well as audio and video taping and dubbing equipment. The Company records its
property and equipment at cost and depreciates it on a straight-line basis over
its estimated useful life, generally three years. The Company regularly
evaluates the remaining life and recoverability of its network equipment, in
light of the emerging nature of its markets.
REVENUE RECOGNITION
Revenues for distribution services are recognized for each transaction
on the date audio, video or related information is successfully transmitted from
the Company's operating facilities to the destination ordered.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to a
concentration of credit risk consist principally of cash and cash equivalents,
short-term investments and accounts receivable. The Company has an investment
policy that limits the amount of credit exposure to any one issuer and restricts
these investments to issuers evaluated as credit worthy.
The Company believes that a concentration of credit risk with respect
to accounts receivable is limited because its customers are geographically
dispersed and the end users (the customer's clients) are diversified across
industries.
The Company's receivables are principally from advertising agencies,
dub and ship houses, and syndicated programmers. The timing of collections from
its customers is affected by the billing cycle in which the customer bills its
end-users (the customer's clients). The Company provides reserves for credit
losses and such losses have been insignificant.
F-9
51
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SUPPLEMENTAL CASH FLOW INFORMATION
Non-cash investing and financing activities for 1998, 1997 and 1996
consisted of the following (in thousands):
FOR THE YEARS ENDED DECEMBER 31,
-------------------------------------
1998 1997 1996
------- ------- -------
Property and equipment financed with capitalized lease obligations $ -- $ 400 $ 8,028
Long-term debt used to finance Mediatech acquisition .............. -- 3,850 --
Common Stock issued to finance Mediatech acquisition .............. -- 1,906 --
Preferred stock deemed dividend ................................... 1,764 15,161 --
Conversion of preferred stock to Common Stock ..................... 31,561 -- 25,321
Note payable used to finance PDR acquisition ...................... -- -- 2,500
Common Stock issued for services rendered ......................... 80 -- --
RECLASSIFICATIONS
Certain amounts in the prior years have been reclassified to conform
with the current year presentation.
4. ACCRUED LIABILITIES:
Accrued liabilities consist of the following (in thousands):
FOR THE YEARS ENDED
DECEMBER 31,
-----------------------
1998 1997
------ ------
Telecommunications costs ..... $ 715 $ 769
Employee compensation ........ 897 734
Legal and consulting fees .... 557 706
Other ........................ 1,912 1,292
------ ------
$4,081 $3,501
====== ======
5. COMMITMENTS AND CONTINGENCIES:
The Company leases its facilities and certain equipment under
non-cancelable operating leases. As of December 31, 1998, future minimum annual
rental payments under these leases are as follows (in thousands):
YEARS ENDING DECEMBER 31,
- -------------------------
1999 ......................... $1,462
2000 ......................... 1,339
2001 ......................... 735
2002 ......................... 520
2003 ......................... 503
Thereafter ................... 1,456
------
$6,015
======
Rent expense totaled approximately $1,391,000, $1,540,000 and $477,000
in 1998, 1997 and 1996, respectively.
In addition, as of December 31, 1998, the Company had non-cancelable
future minimum purchase commitments with its primary telephone service provider.
These commitments range between $3.5 million and $6.2 million per year and
extend through December 2001.
F-10
52
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company is subject to legal proceedings and claims, either asserted
or unasserted, which arise in the ordinary course of business from time to time.
While the outcome of these claims cannot be predicted with certainty, management
does not believe that the outcome of any of the pending legal matters will have
a material adverse effect on the Company's consolidated results of operations or
consolidated financial position.
The Company has employment agreements with certain of its key
executives. In general, the agreements provide for base salaries, bonuses,
option grants based on certain performance criteria, and terminations payments
6. LINE OF CREDIT:
Mediatech is party to a financing agreement with a bank which provides
a revolving line of credit available to fund the working capital requirements of
Mediatech. The maximum available to Mediatech under this agreement is
$3,525,000, dependent upon the level of qualifying receivables maintained by
Mediatech. The agreement is collateralized by a security agreement covering
substantially all of the assets of Mediatech and is guaranteed by the Company.
The interest rate on advances under the agreement is the bank's reference rate,
approximately equal to the prime rate, plus 2.25% (10.0% at December 31, 1998)
and such advances are due and payable on demand. The balances outstanding under
this agreement at December 31, 1998 was $1,433,000 and $2,834,000 at December
31, 1997, which is approximately equal to the maximum amount available under
the agreement at those times.
7. LONG-TERM DEBT:
The Company has used several lease and loan agreements to finance the
purchase of certain property and equipment. Borrowings are secured by the
equipment. The cost of equipment under lease and term loan obligations at
December 31, 1998 and 1997 was $22,588,000 and $21,820,000, respectively.
Related accumulated depreciation at December 31, 1998 and 1997 was $15,644,000
and $11,593,000 respectively. These loans have repayment terms of 36 to 60
months and the Company has the option at the end of the terms to purchase the
equipment at mutually agreed upon prices not to exceed 10 to 20% of the
equipment's original cost. As of December 31, 1998, approximately $0.9 million
remained available under these agreements to fund future capital requirements.
In December 1997 the Company entered an agreement to finance an
additional $2 million of equipment purchases and $3.5 million of working capital
through a long-term facility. At December 31, 1998, $4.6 million has been
financed through this agreement. The agreement has repayment terms consistent
with those discussed above.
Mediatech has long-term debt outstanding per the terms of a promissory
note signed in February 1997. The remaining principal balance of the note was
$1.8 million at December 31, 1998. The note bears interest at the bank's
reference rate, approximately equal to the prime rate, plus 2.25% (10.0% at
December 31, 1998) and principal and interest payments are due monthly. This
note is payable to the same creditor which provides the line of credit discussed
in Note 6 and is collateralized by the same security agreement as the line of
credit. In addition the note is guaranteed by the Company.
Future minimum lease and term loan payments as of December 31, 1998,
are as follows (in thousands):
Years Ending December 31,
- -------------------------
1999................................................................ $ 10,449
2000................................................................ 7,128
2001................................................................ 2,534
2002................................................................ 142
2003 ............................................................... 3
--------
Total minimum debt payments......................... 20,258
Less - Amount representing interest (effective interest rates ranging from 9
percent to 19 percent).......................................................... (2,725)
--------
Present value of minimum lease payments....................................... 17,533
Less -- Current portion..................................... (8,226)
--------
Long-term portion............................................ $9,307
========
F-11
53
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. CAPITAL STOCK:
In February 1996, the Company completed the initial public offering of
its Common Stock. The Company sold 3,000,000 shares for net proceeds of
$29,490,000. Concurrent with the closing of the initial public offering
7,273,759 shares of convertible preferred stock and warrants to purchase 29,161
shares of preferred stock were converted into an equivalent number of shares of
Common Stock.
In July and August 1998, the Company's Board of Directors authorized the
sale and issuance of up to $ 13.0 million of Common Stock in a private placement
transaction. The Company issued 4,589,287 common shares to current institutional
and closely associated investors at $2.80 per share. Proceeds to the Company,
net of issuance costs, was approximately $12.7 million.
In December 1998, the Company's Board of Directors authorized the sale
and issuance of up to $11.0 million of Common Stock in a private placement
transaction. The Company issued 2,920,134 common shares to Scott Ginsburg, the
Company's Chief Executive Officer, at $3.25 per share. In addition, the Company
authorized the sale and issuance of up to $3.0 million of Common Stock in a
private placement transaction. The Company issued 923,078 common shares to
current institutional and closely associated investors at a price of $3.25 per
share.
At December 31, 1998 and 1997, $369,000 and $175,000, respectively, was
receivable by the Company from the issuance of restricted stock. The Company and
Hank Donaldson are parties to restricted stock purchase agreements, pursuant to
which Mr. Donaldson purchased an aggregate of 487,500 shares of the Company's
Common Stock. As of December 31, 1998, a total of 10,158 of these restricted
shares held by Mr. Donaldson were subject to the Company's right to repurchase
within the terms of these stock purchase agreements. The Company and Paul W.
Emery, II, the Company's Chief Financial Officer, are parties to a restricted
stock purchase agreement, pursuant to which Mr. Emery purchased an aggregate of
50,000 shares of the Company's Common Stock. As of December 31, 1998, all of
these restricted shares held by Mr. Emery were subject to the Company's right to
repurchase within the terms of the stock purchase agreement.
As of December 31, 1998, the Company has reserved the following shares
of Common Stock for future issuance:
Number
of Shares
---------
1992 Stock Option Plan........................................................... 2,359,507
1996 Supplemental Stock Option Plan.............................................. 741,250
Stock warrants................................................................... 3,962,067
1995 Director Option Plan........................................................ 100,000
Non-plan Option Plan ............................................................ 75,572
Common Stock to be issued as incentives to certain dealers and distributors...... 20,000
---------
Total potential shares 7,258,396
=========
SERIES A CONVERTIBLE PREFERRED STOCK
During 1997, the Company issued 4,950,495 shares of its Series A
Convertible Preferred Stock (the "Series A Preferred"). The Series A Preferred
was issued at less than the publicly traded price per share. The difference
between the publicly traded price per share and the sales price per share has
been reflected as a deemed dividend to the preferred shareholders in the
accompanying consolidated statements of shareholders' equity. This deemed
dividend is considered a reduction in earnings in the computation of basic and
diluted earnings per share for the twelve months ended December 31, 1997.
In July 1998, the Company's Board of Directors authorized conversion of
all of the Company's Series A Preferred Stock to Common Stock. Each Series A
Preferred Shareholder received 1.1 shares of Common Stock for each Preferred
share converted. The Company's Board deemed this action necessary and
appropriate in order to
F-12
54
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
assure conversion by these shareholders which held certain preferred stock
rights which could have delayed the closing of the Private Placement transaction
discussed above. All 4,950,495 shares of Series A Preferred Stock outstanding at
June 30, 1998 were converted to Common Stock per the terms of the Series A
Preferred Stock Conversion Agreement effective August 14, 1998.
The conversion of the Series A Preferred Stock to Common Stock at a
ratio greater than 1:1 resulted in a deemed dividend to the preferred
shareholders. This deemed dividend is considered a reduction in earnings in the
computation of basic and diluted earnings per share for the twelve months ended
December 31, 1998.
WARRANTS
In connection with certain financing and leasing transactions made in
1993 through 1996, the Company issued warrants to purchase at fair market value
an aggregate of 35,000 shares of Series A preferred stock at a range of $2.00 to
$3.00 per share; 71,174 shares of Series B preferred stock at $2.70 per share;
60,000 shares of Series C preferred stock at $6.00 per share; and 67,500 shares
of Series D preferred stock at $8.00 per share. On December 31, 1995, warrants
to purchase 15,000 shares of Series C preferred stock were canceled pursuant to
the terms of the warrant agreement. A total of 29,161 of the Series A warrants
were exercised in return for surrender of the remaining 5,839 warrants upon the
closing of the Company's initial public offering in February 1996. The remaining
Series B, C and D warrants, which expire on the earlier of ten years from the
date of the related warrant agreement or five years from the effective date of
the Company's initial public offering, were converted to warrants for Common
Stock of the Company as per the conversion terms of the agreements.
In December 1996, the Company issued 9,351 warrants to purchase Common
Stock at $8.02 per share in connection with an increase in an existing lease
line. The warrants expire in 2006.
In January 1997, the Company completed an agreement to finance an
additional $6.0 million of equipment purchases through a long-term credit
facility. Warrants to purchase 112,500 shares of the Company's Common Stock at a
price of $4.42 per share were issued to the lender per the terms of the
agreement.
In December 1997, 186,652 warrants were issued at a price of $4.42 in
connection with a new loan agreement to finance an additional $2 million of
equipment purchases and $3.5 million of working capital through a long-term
facility which can be drawn upon through December 1998.
In December 1998, warrants to purchase 1,921,607 shares of the Company's
Common Stock were issued at an exercise price of $3.25 in connection with the
private placement of Common Stock to certain existing institutional and other
closely associated investors. The warrants are not exercisable for a minimum of
one year and, thereafter, their exercisability is based on the performance of
the Company's Common Stock. The warrants expire in December 2001.
In December 1998, a warrant to purchase 1,548,460 shares of the
Company's Common Stock was issued at an exercise price of $3.25 in connection
with the appointment of the Company's new Chairman of the Board and Chief
Executive Officer. The warrant is not exercisable for a minimum of one year and,
thereafter, its exercisability is based on the performance of the Company's
Common Stock and the continued service of the Company's Chief Executive Officer.
The warrant expires in December 2003.
9. STOCK PLANS:
The Company has three Stock Option Plans:
1992 STOCK OPTION PLAN
Under the Company's 1992 Stock Option Plan, (the "1992 Plan"), the
Company may issue up to 2,950,000 shares of Common Stock to employees, officers,
directors and consultants. At the Company's Annual Shareholders' Meeting in
April 1998, the shareholders approved an increase of 500,000 shares from the
previously authorized total of 2,450,000. The exercise price and terms of the
options granted is determined by the Board of Directors, provided that such
price cannot be less than the fair value of the Common Stock on the
F-13
55
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
date of grant for incentive stock options or, in the case of non-statutory
options, less than 85 percent of the fair value of the Common Stock on the date
of grant. The options generally vest over four to five years. The 1992 Plan
provides that, in the event of a change in control of the Company, executive
officers of the Company will receive accelerated vesting for a portion of their
unvested option shares. The term of the options granted is seven years.
1996 SUPPLEMENTAL OPTION PLAN
In 1996, the Company's Board of Directors adopted the 1996 Supplemental
Option Plan. Under this Plan, the Company may issue up to 750,000 shares of
Common Stock to employees, officers, directors and consultants. The exercise
price and terms of the options granted is determined by the Board of Directors.
The options generally vest over four years. The term of the options granted is
seven years.
1995 DIRECTOR OPTION PLAN
In 1995, the Company's Board of Directors adopted the 1995 Director
Option Plan (the "Director Plan"). A total of 100,000 shares of Common Stock has
been reserved for issuance under the Director Plan. The Director Plan provides
that each future non-employee director of the Company will be automatically
granted an option to purchase 10,000 shares of Common Stock (the "First Option")
on the date on which the optionee first becomes a non-employee director of the
Company and an additional option to purchase 2,500 shares of Common Stock (the
"Subsequent Option") on the next anniversary. The exercise price per share of
all options granted under the Director Plan shall be equal to the fair market
value of a share of the Company's Common Stock on the date of grant of the
option. Shares subject to the First Option vest over 36 months, and the
Subsequent Option shares vest over 12 months beginning with the month following
the second anniversary of its date of grant. The terms of the options granted is
ten years.
ACCOUNTING FOR STOCK OPTION COMPENSATION EXPENSE
Effective January 1, 1996, the Company adopted the disclosure provisions
of Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for
Stock-Based Compensation." The adoption did not have a significant effect on the
Company's results of operations as the Company continues to apply the principles
of APB Opinion No. 25 and related interpretations in accounting for the
Company's stock options plans. Had compensation cost for the Company's stock
option plans been determined based on the fair value at the date of grant of the
stock options consistent with the method of SFAS No. 123, the Company's net loss
(in thousands) and loss per share would have been changed to the pro forma
amounts indicated below:
1998 1997 1996
---------- ------------ -----------
Net Loss As reported $ (30,237) $ (14,775) $ (9,127)
Pro forma $ (32,230) $ (15,696) $ (10,174)
Basic and diluted net loss per common share As reported $ (1.97) $ (2.52) $ (0.87)
Pro forma $ (2.09) $ (2.59) $ (0.97)
The fair value of each option grant is estimated on the date of grant
using the multiple option approach of the Black-Scholes option pricing model
with the following assumptions used for grants in 1998, 1997 and 1996: risk-free
interest rates, based upon the grant dates, ranging from 4.7% to 7.8%; expected
dividend yields of zero percent; expected lives of one year from the vesting
date; expected volatility of zero percent prior to the filing date of the
Company's February 1996 initial public offering and sixty-five percent for
grants made subsequent to the filing through December 31, 1996; seventy-five
percent for grants made between January 1, 1997 and December 31, 1997; and one
hundred ninety-four percent for grants made between January 1, 1998 and December
31, 1998.
A summary of the Company's fixed stock options plans at December 31,
1998, 1997 and 1996 and changes during the years then ended is presented below:
F-14
56
1998 1997 1996
----------------------- ------------------------ ------------------------
WTD AVG EX. WTD AVG EX. WTD AVG EX.
SHARES PRICE SHARES PRICE SHARES PRICE
---------- ---------- ---------- ----------- ---------- -----------
Outstanding at beginning of the year 2,532,707 $4.11 1,806,355 $5.29 1,456,500 $1.73
Granted 1,270,250 3.12 2,037,000 4.87 842,500 9.14
Exercised (164,701) 2.25 (144,699) 0.55 (238,501) 0.43
Canceled (701,225) 4.61 (1,165,949) 7.71 (254,144) 2.20
---------- ----- ---------- ----- ---------- -----
Outstanding at end of the year 2,937,031 $3.67 2,532,707 $4.11 1,806,355 $5.29
---------- ----- ---------- ----- ---------- -----
Exercisable at end of the year 1,075,332 $3.65 494,276 $2.54 378,797 $2.29
Weighted average fair value of options granted $2.85 $2.65 $4.41
The following table summarizes information about stock options
outstanding at December 31, 1998:
Options Outstanding Options Exercisable
- --------------------------------------------------------------------------------------- ----------------------------------------
Number Weighted-Average Weighted-Average Weighted-Average
Range of Exercise Prices Outstanding Remaining Contractual Life Exercise Price Number Exercisable Exercise Price
- ------------------------ ------------ -------------------------- ---------------- ------------------ ----------------
$0.20 - $2.65 598,955 4.56 $1.55 307,734 $0.76
$2.75 - $5.00 2,057,118 5.72 $3.93 653,637 $4.56
$5.625 - $10.125 280,958 5.67 $6.28 113,961 $6.31
--------- ---------
$0.20 - $10.125 2,937,031 1,075,332
========= =========
As of December 31, 1998, there were 339,298 shares available for future
grant under the stock option plans.
Subsequent to December 31, 1998, the Board of Directors granted options
to purchase 214,000 shares at $5.88 per share.
10. INCOME TAXES:
The Company accounts for taxes using a liability approach under which
deferred income taxes are provided based upon enacted tax laws and rates
applicable to the periods in which the taxes become payable. Because of the
losses incurred to date, the Company has not required a tax provision.
F-15
57
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Components of the net deferred income tax asset are as follows (in
thousands):
1998 1997
-------- --------
Net operating loss carryforwards .... $ 16,338 $ 12,702
Cumulative temporary differences .... 3,366 2,175
Capitalized start-up costs .......... -- --
Research and development credit ..... 768 543
Valuation allowance ................. (20,472) (15,420)
Net deferred income tax asset ....... $ -- $ --
======== ========
The net operating loss and research and development credit carryforwards
of approximately $44.1 million and $768,000, respectively, will expire on
various dates through December 31, 2007. Utilization of these carryforwards may
be annually limited if there is a change in the Company's ownership, as defined
by the Internal Revenue Code.
A valuation allowance has been recorded for the entire deferred tax
asset as a result of uncertainties regarding the realization of the asset
including the limited operating history of the Company, the lack of
profitability to date and the variability of operating results.
11. NET LOSS PER SHARE:
Under Statement of Financial Accounting Standards (SFAS) No. 128
"Earnings per Share," the Company is required to compute earnings per share
under two different methods (basic and diluted). Basic earnings per share is
calculated by dividing net income (loss) by the weighted average shares of
Common Stock outstanding during the period. Diluted earnings per share is
calculated by dividing net income (loss) by the weighted average shares of
outstanding Common Stock and Common Stock equivalents during the period. Due to
losses, inclusion of Common Stock equivalents would be anti-dilutive. Therefore,
basic and diluted earnings per share for the Company are the same.
For the year ended December 31, 1998, the net loss per share was
computed as net loss of $30,237,000 plus $1,764,000 relating to the preferred
stock deemed dividend divided (Note 8) by the weighted average common shares
outstanding. For the year ended December 31, 1997, the net loss per share was
computed as net loss of $14,775,000 plus $15,161,000 relating to the preferred
stock deemed dividend divided by the weighted average common shares outstanding.
12. SEGMENT INFORMATION:
In 1998, the Company adopted Statement of Financial Accounting Standard
No. 131, "Disclosures about Segments of an Enterprise and Related Information."
The Company operates predominantly in one industry segment: digital and physical
distribution and post-production services for audio and video content, and its
operations are managed primarily by geographic areas. The Company has defined
its reportable segments based on these geographic areas.
The information in the following tables is derived directly from the
segments' internal financial reporting used for corporate management purposes.
The expenses, assets and liabilities attributable to corporate activity are not
allocated to the operating segments. As of December 31, 1998, 19% of operating
assets are located outside of the United States. The balance sheet information
for the Company's Los Angles segment is maintained as part of the Chicago
segment and is impractical to break out separately.
F-16
58
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Twelve Months Ended December 31, 1998
In $000's
--------------------------------------------------------------------------------------------------
Adjustments &
San Francisco New York Chicago Los Angeles Vancouver Eliminations Consolidated
Operating revenue $ 20,454 $ 10,125 $ 10,829 $ 2,842 $ 1,498 $ (4,478) $ 41,270
EBITDA* (2,295) 1,888 339 110 (245) -- (203)
Depreciation and amortization 6,230 623 2,925 301 187 -- 10,266
Writedown of subsidiary 17,006 17,006
Operating income (loss) (8,525) 1,265 (19,593) (191) (432) -- (27,476)
Interest expense (2,627) -- (382) -- (5) (3,014)
Interest and other income 243 -- -- -- -- 243
Income before taxes $(10,910) $ 1,265 $(19,975) $ (191) $ (426) -- $(30,237)
At December 31, 1998
Identifiable assets 60,984 10,060 7,514 -- 9,481 (38,247) 49,792
Total assets $ 60,984 $ 10,060 $ 7,514 $ -- $ 9,481 $(38,247) $ 49,792
Long-lived assets 5,654 562 4,227 -- 1,302 -- 11,745
F-17
59
For the Twelve Months Ended December 31, 1997
In $000's
--------------------------------------------------------------------------------------------------
Adjustments &
San Francisco New York Chicago Los Angeles Vancouver Eliminations Consolidated
Operating revenue $ 14,367 $ 8,384 $ 7,330 $ -- $ -- $ (906) $ 29,175
EBITDA* (3,921) 1,015 (700) ` -- -- (3,606)
Depreciation and amortization 7,236 607 1,463 -- -- -- 9,306
Operating income (loss) (11,157) 408 (2,163) -- -- (12,912)
Interest expense (2,330) -- (277) -- -- (2,607)
Interest and other income 742 -- 2 -- -- 744
Income before taxes $(12,745) $ 410 $ (2,440) $ -- $ -- $ -- $(14,775)
At December 31, 1997
Identifiable assets 51,689 2,486 28,214 -- -- (21,692) 60,697
Total assets $ 51,689 $ 2,485 $ 28,214 $ -- $ -- $(21,692) $ 60,697
Long-lived assets 10,082 568 6,916 -- -- -- 17,566
For the Twelve Months Ended December 31, 1996
In $000's
--------------------------------------------------------------------------------------------------
Adjustments &
San Francisco New York Chicago Los Angeles Vancouver Eliminations Consolidated
Operating revenue $ 9,587 $ 938 $ -- $ -- $ -- $ (2) $ 10,523
EBITDA* (4,595) 103 -- -- -- -- (4,492)
Depreciation and amortization 4,230 30 -- -- -- 71 4,331
Operating income (loss) (8,825) 73 -- -- -- (71) (8,823)
Interest expense 1,724 -- -- -- -- 1,726
Interest and other income 1,421 1 -- -- -- -- 1,422
Income before taxes $ (9,130) $ 74 $ -- $ -- $ -- $ (71) $ (9,127)
At December 31, 1996
Identifiable assets 44,964 1,830 -- -- -- (1,546) 45,248
Total assets $ 44,964 $ 1,830 $ -- $ -- $ -- $ (1,546) $ 45,248
Long-lived assets 12,087 543 -- -- -- -- 12,630
*Earnings before interest, taxes, depreciation and amortization.
F-18
60
13. PRETAX SAVINGS PLAN:
The Company has a 401(k) retirement plan for full-time U.S. based
employees. Employees who are at least 21 years of age and have completed at
least six months of service are eligible to participate in the plan. Employees
may contribute up to 20% of gross pay with a maximum dollar limit for 1998 of
$10,000. The employer contribution is made at the end of the plan year in an
amount set by corporate resolution, based on participants' compensation. The
Company made no contributions to the plan in 1998, 1997 or 1996 to the plan.
14. NEW ACCOUNTING STATEMENT OF POSITION
In February 1998, the American Institute of Certified Public
Accountants ("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use,"
which requires the capitalization of certain costs related to the development
of software for internal use. The Company will adopt this SOP in fiscal year
1999. The Company does not believe that adoption of this statement will have a
material effect on its financial statements.
F-19
61
DIGITAL GENERATION SYSTEMS, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
BALANCE AT ADDITIONS
BEGINNING OF CHARGED TO BALANCE AT END OF
CLASSIFICATION PERIOD OPERATIONS OTHER (a) Write-offs PERIOD
------------ ---------- ---------- ---------- -----------------
Allowance for Doubtful Accounts
Years Ended:
December 31, 1996 ........ $ 135,000 $ 97,000 $ 25,000 $ -- $ 257,000
December 31, 1997 ........ $ 257,000 $ 246,000 $ 259,000 $ (177,000) $ 585,000
December 31, 1998 ........ $ 585,000 $1,142,000 $ 186,000 $ (18,000) $1,895,000
(a) Additions resulting from acquisitions of PDR in 1996, Mediatech in 1997
and DCI in 1998.
S-1